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Theory of accounting practice (spot only)

Accounting Theory
Normative Accounting (1956-1970) Normative period

It refers to the period when theorist attempted to establish norm for


best accounting practice.
Debate predominantly about measurement rather than actual practice
of recording and reporting.
During this period, less concern about what actually happened in
practice and more concerned about developing theories that
prescribed what should happen.
Two groups dominated the normative period the critics of historical
cost accounting and the conceptual frameworks proponents.

Positive Accounting (1970)

Dissatisfaction with normative theories.


It is based on empirical (practical) approach. That is, whether what
practicing accountants produced had a decision usefulness objective,
whether it filled other roles, and whether it was inferior or superior to
proposed alternative.
More focus on providing explanation on the practice which was being
observed.
Objective of PA is to explain and predict. An example of PA is the
theory that leads to what is known as the bonus plan hypothesis.

REGULATORY APPROACHES
a. Public interest theory

Is based on assumption that economic markets are subjected to


series market imperfections or transaction failures, which are, if
left uncorrected, will result in both inefficient and inequitable
outcomes.
Mainly to correct the market failure due to the demand from the
public.
Regulatory body is assumed to serves the best interest to public,
and government is a neutral arbiter.
Public interest theory is also based in further assumptions.
First, the interest of consumers is translated into
legislative action through the operation in the internal
market place.
Second, there are agents who will seeks regulation on
behalf of the public interest.
Third, government is a neutral arbiter.

Criticism
Complex task in deciding the right amount of regulations
Regulation carries substantial costs (ex: compliance cost)
Regulator will operate to serve his benefits rather than
operate on behalf of the best interest of the public.

b. Capture theory
Origin of the regulation is to protect the public interest however
this purpose is not achieved because in process of regulation, the
regulatee comes to control the regulator.
Assumption on capture theory :
People are economical rationally. Each person will pursue
his self-interest to the point where the private marginal
benefit from lobbying regulators just equals the private
marginal costs
Regulation has the potential to redistribute wealth,
therefore, people lobby for regulations that increase their
wealth.
Government has no independent role play in the
regulatory process, and that interest groups battle for
control of the governments coercive powers to achieve
their desired wealth distribution.
Capture theory is said to occur when regulated entities :
Control the regulation and the regulatory agency
Succeed in coordinating the regulatory bodys activities
with their activities, so that their private interest is
satisfied.
Regulatory decisions usually have major effects on their interest
of regulated industries. Therefore, they generate intense activity
aimed at influencing the regulatory agency.
Regulatory capture theory suggest that professional bodies or the
corporate sector will seek as much control as possible over the
settling of accounting standards governing the reporting by their
members. This involves :
Formal control over standard setting representation on
the relevant standard setting bodies.
Significant control over the decision made by the relevant
standard setting bodies.
Criticism
No reason suggest that regulated industry is the only
group able to influence the regulator
No reason why regulated couldnt prevent creation of the
regulatory agency.
c. Economic interest group theory (Private interest theory)

Regulation of an industry mainly set to take care of particular


special interest group to maximize their interests.
Regulation is more competition for power rather than to protect
the public interest.
Government is not neutral arbiter, they owned power to coerce,
and it is a potential resource or threat to every business firm.
For future electoral success, government sells aspect their right in
the form demand regulation to be protected from foreign price
competition.
The interest group theorist believe that there is a market for
regulation with similar supply and demand forces operating as in
capital market.
Within the political market there are many bidders, however, only
one group that makes the highest bid will successful.
Regulation serves the private interest of politically effective groups; those
groups with insufficient power will not be able to effectively lobby, for
regulation to protect their own interest.

Comparing deductive and inductive approaches:


The Deductive Approach
Constructions of AT theory begins with basic propositions & proceeds to
derive logical conclusions about the subject under considerations.
Move from general to particular
Steps used to derive the deductive approach
1. Specifying the objectives of financial statements
2. Selecting the postulates of accounting
3. Deriving the principles of accounting
4. Developing the techniques of accounting
The Inductive Approach

The construction of theory begins with observations & measurements &


moves toward generalized conclusions.
Lead to Positive approach
In the inductive approach, the truth or falsity of the propositions does not
depend on other propositions, but must be empirically verified
In the inductive approach the truth of the propositions depends on the
observation of sufficient instances of recurring relationships
Accounting propositions that result from inductive inference imply special
accounting techniques only with high probability
Involved four stages, i.e. :1. Recording all observations
2. Analysing and classifying these observations to detect recurring relationships
3. Inductive derivation of generalisations and principles of accounting from
observations that depict recurring relationships
4. Testing the generalisations

Conceptual framework & Standard Setting Process


Conceptual Framework

Guide in the development of consistent accounting standard


CF is a coherent system of interrelated objectives and fundamentals
that is expected to lead to consistent standard
Provides the nature, purpose, and guideline of financial accounting
and reporting in practice
Aims to reduce inconsistent practices, delimit the potential for
political interference, and enable better understanding of reporting
requirement
A descriptive framework: which serve to codify and explain the
existing financial reporting practices
A prescriptive framework: attempts to develop conceptual basis
for what financial accounting practices should be.

Why to have Conceptual framework?


a Lack of general theory
Some dont have the standard to follow, some is use GAAP/IFRS
Formulating general theory from CF
Lack of CF causes the bad practice triumph over good practice
b Permissiveness of accounting practice
Accounting practice is overly permissive alternative accounting
practice to be applied to similar circumstances
Example, LIFI, FIFO, weighted-average
The more practical alternative would be to leave the every
organization freedom to choose within broad limit.
c Inconsistency of practices
Allowing entities to select their own accounting method within
the boundaries of GAAP
Some accounting policy can be implemented by making a value
judgement but there is no way of providing that the value
judgement is better for society.
Accounting regulators issuing various resolution and accounting
standard
Some early regulators were supported by arbitrary argument
d Defence against political interference
To avoid monopoly of one political body
Solomons think CF as a defence against politic interference I
neutrality of accounting report
He discovers that accounting policy can be implemented only by
making value judgement.

Benefits of Conceptual Framework


Reporting requirement will be more consistent and logical because
they will stem from an orderly set of concept
Avoidance of reporting requirement will be much more difficult because
of existence of all-embracing provisions
Preparer and auditor should be able to better understand the financial
reporting requirement since it is under the supervision and
maintenance of CF
He setting of requirement should be more economical because issues
should not need to be re-bated from different viewpoint (reduce
conflict)
Provide a frame reference for resolving accounting question in the
absence of specific promulgates standard.
Enhance comparability and accountability by decreasing the number of
alternative accounting methods, minimize the risk of over regulation.
The need for specific accounting standards will be reduced to those
circumstances in which the appropriate application of concepts is not
clear.

Objectives of Conceptual framework

To provide information to users that is useful in making and evaluating


decisions about the allocation of scarce resources

Objectives financial statements

General objectives to present fairly and inconformity with GAAP,


financial position, result from operation and other changes in financial
position
Provide reliable information about economic resources and obligation
of business entities (ex: evaluate its strange and weakness) shows its
financing and investment, show its resource base for growth
To provide financial information that can be used to estimate earning
potential of the entities
To disclose other information relevant to statement user( ex:CSR)
To provide another need of information about change in economic
resource and allocation.
To provide reliable information about changes in net resources
resulting from a business enterprises profit directed activities in order
to show expected dividend return to various and provide management
information for planning and control.

Component of CF (Overall Scope) [3 level]

1st Level: Objectives of CF


a Useful in making economic decisions
The information is useful to present and potential investors and
creditors and other users in making rational investment, credit and
similar decisions.
b Useful in assessing cash flow prospects
Assessing a future net cash flow on the firm to determine the
capacity of company pay to its employees, supplier and creditors.
c About enterprise resources (assets), claim on it and changes in them
Financial statements must have the information to show by notes to
account that whether there is a change for the companys financial
positions.
2nd Level: Fundamentals
a

Qualitative Characteristics
i Understand ability
Refers to ability of information to understood by users
Users are assumed to have a reasonable knowledge of
business and economic activities and accounting, and
willingness to study the information with reasonable diligence.
ii Relevance (PFT)
Relevance information help users to evaluate the past,
present and future events (Predict Value) or to correct the
prior expectation (Feedback Value)
Information must be timeliness before it loss capacity to
influence decision maker.
iii Reliability (FVN)
Information should be faithfully represented transactions and
events without material bias or error.
Faithful representation
Refers to the relationship between accounting data
and the events of those data are supposed to
represent.
Verifiability
Get same result by examination same data.
Neutrality
Unbiased
iv Consistency
The accounting apply must same for every years
v Comparability
Refers to report the information for different entities in a
similar manner.

It is also indicates that comparable financial statements are


not necessarily the same, but merely allow suitable
comparisons.
vi Materiality
Information is material if the information could influence
decision making
vii Substance over form
The information is presented faithfully, accounted for and
presented in accordance with their substances and
economic reality and not merely their legal form.
The information must be fairness, transparency,
trustworthiness information.
All these will provide a true economic reality of an entity.
Therefore, substance over form in the transaction or events is
inconsistent from the legal perspective.
b Element of financial statements
i Assets probable future economic benefit
ii Liabilities probable future sacrifices of economic benefits
arising from present obligations
iii Equity residual interest in the assets of an entity that
remains after deducting its liabilities.
iv
Revenue increase in NA from operation.
v
Expenses decrease in NA (net asset) from operation
vi Comprehensive Income changes to equity from nonowners sources.
vii Gain increase in NA from non-operating activities
viii Loss decrease in NA from non-operating activities
3rd Level: Recognition and Measurement Concept
Four basic assumption of accounting are;
a Economic entity
The owner and business is treated as different entity
b Going concern
Company is assumed to have a long life unless terminated by
owners
c Monetary unit
Money is used as basic in measurement
d Periodicity
Economic activities can be divided into artificial period such as
weekly, monthly and etc.
Four basic principle of accounting are:
a Historical
Acquisition cost should be reported in FS

b Revenue Recognition
Recognized revenue when earned and realized
c Matching Principle
Expenses is matched to the revenues they help to generate
d Full disclosure
Provide information that is sufficient to influence the judgement
and decisions to decision maker.
Standard Setting Due Process in Malaysia
MFRS are words to words IFRS issued by the IASB except for the
nomenclatures
due process of MFRS Framework aligns the MASB's due process
timeline to that of the IASB with the aim of putting the new or
amended standards in place for adoption and application within a
timely manner
to ensure that the effective date of the new or amended standards will
be the same as that of IFRSs
STAGE 1: The MASB seeks public comment on IASB's draft technical
pronouncements
Technical pronouncement includes Discussion Paper, Exposure Draft,
Request for View.
MASB will disseminate the IASB draft technical pronouncement
together with an invitation to comment to local constituents by
publishing on MASB website a Comment Online feature and sending
a copy of the documents to the relevant authorities, professional
bodies, accounting firm, industry related association and public listed
companies.
The due date for the public to submit comment to MASB is usually on
month before IASBs comment deadline so as to allow MASB Working
Group and the Board a reasonable time to consider the comments
received before making a submission to the IASB
Public forum may be recognized if these IASB draft pronouncement
represent major change of shift from current practice.
STAGE 2: Deliberation at the Work Group level on IASBs draft
pronouncement
The IASBs draft pronouncements and public comments received will
be deliberated by the WG.
After due deliberation, the WG will provide comments and
recommendations to the issues raised on in the draft pronouncements
for the MASBs consideration.
STAGE 3 & 4: Deliberation by the MASB
All public comments received, WG's comments and recommendations
will be tabled to the MASB for deliberation and consideration

During the discussion, the MASB will consider all comments received
and thereafter, a comment letter to the IASB will be prepared and
submitted to the IASB accordingly.
STAGE 5, 6, & 7: Issuance of Standard by the IASB
Following publication of the new or amended IFRS by the IASB, the WG
will deliberate on the changes made, if any, to the draft
pronouncements.
Thereafter, the WG's recommendations including possible issues/
implications, if any, of the IFRS will be presented to the MASB for
consideration.
STAGE 8, 9, & 10: Issuance of standard by the MASB
After due deliberation by the MASB, a copy of the MFRS (word-for-word IFRS)
would be presented to the FRF members for their comments before it being
issued as approved accounting standards in Malaysia

IASB AND FASB


Origin

IASB (FRAMEWORK)
United Kingdom
Develop IFRS
Principle based
Focus on financial
statement

Objectives

Focus on information
needs of a wide range of
users

Enterprise
resource

Performance
Changes in financial
position

Comparative
and other
qualitative

Financial statements are


prepared on the accrual
basis
Reporting entity should be
going concern
Two (2) elements of
changes in assets and

FASB(CONCEPT STATEMENT)
United states
Non-profit organization
Develop GAAP
Rule based
Focus on financial
reporting
Emphasizes usefulness
in
investment and
credit decision

Performance and
comprehensive income
Liquidity
Solvency
Funds flows
The need of accrual
accounting
Briefly discuss the going
concern but do not
emphasized on it
Three (3) elements of
changes in assets,

liabilities, which are


income and expenses

Qualitative
characteristi
cs
Recognition

Measuremen
t

Inventory

Extraordinar
y item

Developmen
t costs
Contract

Understandability
Relevant
Reliability
Comparability
Include the criterion that it
must be probable that any
future economy benefit as
a recognition
Do not specify the
relevant criterion
Less emphasize on use of
cash flow statements
Less use PV as
measurement technique
Prohibited the use of LIFO
(assets acquired last is the
first been sold)
Prohibited
Extraordinary items are
not segregated in the
income statement
Capitalized development
cost
Company can only settle
contract by cash

liabilities, which are


revenues, expenses,
gains and losses

Understandability
Relevant
Reliability

Do not include
probability as a
recognition criterion
Criterion that included
must be relevant

Specifies use of a cash


flow statements
Use PV as measurement
technique
LIFO and FIFO as a
common method for
recording inventory
Allow
Below the net income

Development cost as
expense
Choices given to the
company either to settle
contract by cash or
shares

Earning Management & Game Theory


EARNING MANAGEMENT (EM)
EM is the choice by a manager of accounting policy or real actions,
affecting earning so as to achieve some specific reported earning
objectives. It is a strategy used by management of a company to
deliberately modify the companys earning so that the figures match
the pre-determined target
Manager can manage earnings because they have flexibility in making
accounting choices

EM also known as creative accounting which used to manage the


financial numbers within letter of law and accounting standards
Creative accounting also will be inflate profit figure like some
company may also decreased reported profit in good years to
smooth the results and in order to hide the problem that occur in
the company
CA is flexible, whereby from this flexibility it provide
opportunities representation until sometimes not providing true
and fair view of the company accounting
EM can be viewed from both financial reporting and contracting
perspective
o Financial reporting perspective

Manager use EM to meet analysts forecast earning, thereby


avoiding the reputation damage and the decrease share price when
the objectives is not meet

Management may use EM to report a stream of smooth and


growing earnings
o Contracting perspective
EM can be used as a way to protect the firm from the
consequences or unforeseen events when contract are rigid and
incomplete
Example company wants to borrow a loan from bank but the
borrowing conditions is too strict, so the company manipulate the
earnings to show there is a growth in profit
Importance of EM
o Enables an improved understanding of the usefulness of net
income, both for reporting to investors and for contracting
o Assist accountants to avoid serious legal and reputation
consequences that arise when the firm become financial distressed
Disadvantage
o Aggressive EM reduce the usefulness if financial report for
investors
o Affect the managers motivation to extent effort, because
managers can use EM to smooth their compensation over time,
thereby reducing compensation risk
EM includes both accounting policy choices and real actions
Techniques of EM
i Cooking the jar
o Deals with estimations of future events. The management has to
estimate the obligation that will be paid in the future as a result
of current year transaction based on accrual basis. They will try
to overestimate expenses during the current period, when actual
expenses turn out lower than estimates, the different put into the
cooking jar to be used

o Example : sales returns and allowance, estimate bad debts


ii Capitalization practice
o Company capitalized the cost of internal development software
and amortize it over the useful life. The allocation of more
expenses to a project is more likely to capitalize them to
decrease current operating expenses
iii Throw out a problem child
o Increase earning by sell the subsidiary which is not performed
well. A gain or loss is reported in the current period statement
when the subsidiary is sold.
iv Big bet on the future
o When an acquisition occurs it must be reported as purchase
under GAAP. Company can manage earning by writing off
continuing R&D costs against current earning in the acquisitions,
the cost will not have to reported in the future and thus future
earnings will boost.
Pattern of Earning Management
A Taking a bath
o This can take place during periods of organization distress or
reorganization
o If company must report loss, report a large one. This practice
enhances the probability of profit in the future.
o It happens when net income below the bogey.
o Example:
When new CEO entering poorly performing firm, he will tend
to manage the earning to become better than before. The
manager may take a bath by writing off investments in capital
assets and setting up provision for future costs. This will
reduce the current reported period income, but enhances the
probability of future reported period due to the accrual
reversal.
B Income Minimization
o Similar as taking a bath but less extreme (if net income above the
cap).
o Take place during period of high probability of firm with high political
costs (tax).
o Involves rapid write off of capital assets, intangible, advertising and
R&D costs for the purpose to minimize the political costs (tax
evasion/relief).
o Example:
Company involves in earning management by revise number
downward in order to get help from the government, because
the low profit may get more sympathetic from governing.

C Income Maximization
o When the income is between the bogey and cap
o Manager involves in earning manager for the bonus purposes
(bonus hypothesis) and firms that close to debt covenant violations.
o Manager report high income in order to maximize his own selfinterest.
o Manager close to debt covenant violations report high net income to
get the lenders, they did not know the true picture of the
organization.
D Income Smoothing
o It is for when inflation period.
o Similar to income maximization but try to sustain income between
the bogey and cap.
o Managers are more likely to receive less variable bonus stream,
they use income smoothing to ensure the constant compensation.
o To reduce volatility if reported income so as to smooth covenants
ratio over time, because the more volatile the stream reported
income, the higher the probability that covenant violation will
occurs.
o Consequences of income smoothing:
Shows a good signal to the whole market
Maintain management reputation
Reduce the possible of reporting low income
Convey insider information to investors
Good EM
a Unblocked communication within management and users of
financial statements.
o EM can serve as a way to unblock communication to
outsiders. Blocked communication exists when it is very
difficult and costly to translate an expertise about a firm to
the BOD. By using the FS, EM can be used to inform outsiders
of managements inside information as their expertise.
o EM serve as a tool to convey inside information to
stakeholders and the transmitted information is more credible
as it is being presented in the financial statements.
b Efficient contracting
o Manager chooses accounting policies to attain corporate
governance objective of the firm and conservative accounting
to efficient contract.
o Assume that compensation contract and internal control
system, good corporate governance and limit opportunism
motivate managers to choose accounting policy to control
contracting costs, thereby benefiting the firm and its
shareholders.

o Aims to minimize agency costs and maximizing the value of


the firm.
o Efficient contracting occurred when contract impose strict or
incomplete term on manager. It is desire to give managers
some ability to manage earning in face of incomplete and
rigid contracts. If manager goes to far and behave
opportunistically with respect to existing contract it will be a
bad earning management.
c Good value to the firm
o Occur when the earnings are smoothed to increase the
associated between reporting earnings and firm value.
o Smooth earnings make the reported earnings figure more
informative and also give a good perception for public.
o Earning management also helps investors from rational
expectation about firm values because firms that engaged in
EM are economically stronger.
Bad EM
a Opportunistic behaviour
o Manager chooses accounting policies to maximize their own
expected utility relative to their own remuneration and debt
contracts and political costs.
o Managers exploit their power in the organization by
maximizing their utility at the expense of the firms,
shareholders, and investors.
o When managers of a company are remunerated in accordance
to the level if earnings as status in bonus plan hypothesis,
they are less likely to receive variable bonus stream, they
tend to reduce the degree of fluctuation of earnings.
o The opportunistic behaviour lead manager to manage earning
upward although it is illegitimated to do so. (The upward
earning is very difficult to detect, since reduced future
amortization charges and other expense reductions are buried
in larger totals.)
o A variety of discretionary accruals can be used to increase
reported income in the short run. Example:
Speeding up revenue recognition
Lengthening the useful life of capitals assets
b Do managers accept Securities Market Efficiency
o Evidence of good earning management is consistent with
managers relief that markets are reasonably efficient.
However, evidence of bad earnings may or may not consistent
with efficiency.
o Manager feels they can fool the market by managing the firm
earnings. They may hide behind poor disclosure. This means

that the managers do not want to disclose all of the related


information if they refuse to accept Securities Efficient Market.

EARNING MANAGEMENT
It is a strategy used by the management of a
company to influence/ manipulate reported
earnings by using specific accounting methods,
such as deferring/accelerating
expense/revenue transaction.
This practice is carried out for the purpose of
income smoothing. Thus the company will be
able to make its earning relatively stable from
year to year.
It is not illegal
Usually involves the artificial increase/decrease
of revenues, profits/earnings per share figure
through aggressive accounting tactics.

Occurs when management use judgement in


financial reporting and in structuring
transactions to alter financial reports to other
mislead some stakeholders about the
underlying economic performance of a
company/influence contractual outcomes that
depend on reported accounting numbers.

FRAUDULENT REPORTI
Fraudulent financial reporting is a
act taken by executives within a c
intentionally conceal financial info
about the company and to deceiv
about the wealth of the company.

Is an illegal act
Management manipulating/emitti
financial figures with the differenc
fraud usually has substantial mist
drastically change the bottom lin
of a company.
When a company commits fraud
reporting and is caught, the pena
substantial. They are usually expe
enormous fines to the governmen
compensate their shareholders, a
executives potentially paying tim

Game Theory (GT)


GT attempts to model and predict the outcome of conflict between
different constituencies of financial users.
It is the interaction between 2 or more players, the interaction occurs
in the presence of uncertainty and information asymmetry. Each player
is assumes to maximize his or her expected utility
Functions :
GT helps us to understand how manager, investors and other
affected parties can rationally deal with the economic
consequences of financial reporting
It helps the user to see how the theory of ESM is not necessarily
inconsistent with EC and helps us to see why contracts
frequently depend on financial statements

GT attempts to mathematically capture behaviour in strategic


situation, in which an individuals success in making choices depends
on the choices of others. Choices / action of the other can be extremely

difficult to predict since the choices chosen by one player will depend
on what action that player thinks the other players will take
GT model shows that an accounting standard setting body that fails to
consider the interest of all constituencies affected by policy choice is in
danger of making policy recommendations that are difficult to
implement.

4.3.1 Agency Theory (also known as GT)*


Defined as a contract under which one / more persons (principles)
engage another person (agency) to perform some service on their
behalf which involves delegating some decision making authority to
the agent. (firm delegate authority to BOD, BOD delegate to CEO)
There are 2 types of agency relationships which are between firm
(principal) and manager (agent), and between bondholder (principal)
and manager (agent)
Both parties are not specifically agree to take certain actions but
motivated by contract itself
The agency theory suggest that, the separation of ownership and
control can give rise to agency cost because of the conflict of interest
between the contracting parties (firm and managers)
The theory aims to explain and predict the actions of agents and
principal
4.3.2 Agency problems
Information Asymmetry (IA) (info gap)
Principal and agent relationship are affected by uncertainty, which
refers to the uncertainty in the level of agents knowledge, skills,
liabilities and whether agents acting in the principals best interest
The difference of info between principal and agent is known as
information asymmetry (when 1 seller know something about the
assets being traded than another does not know)
Information asymmetry describes inability of the principal to properly
assess whether the action choose by the agent is in the principals best
interest.
IA occurs when principals ability to monitor the agents behaviour is
limited or restrained. The situation causes the agent to decrease their
performance because of their ability to hide such deficiency info
(Manipulate data/ adverse selection)
Impact :
It will hamper the proper operation of market (for ESM)
It causes the market exist bur not work properly (ESM)
Moral hazard problem occurred when the user try to cheat
for their own benefit

Adverse selection (selected only good result) occurred


when they use the opportunity of IA on the markets to gain
money
Fully disclosure and timeliness reporting in FR reduce
adverse selection
The possibility of adverse selection, creates estimation risk
for investors, if the risk is not fully diversification, it
increases firms cost of capital
There are 2 types IA
Adverse selection
Moral hazard
Cooperative*
The situation refers to that the players in a conflict can enter in
agreements (contract) that they perceive as binding
2 types perceive as binding
a. Employment contracts (firm and manger)
o The firm is the principal and the manager is the agent
o The employment contract involved the firm owner (shareholders)
and the manager
o The principal (firm) compensates an agent (manager) to act
behalf of him
o The conflict of interest arise, when manager seek to maximize
his own utility at the expense of shareholders (bonus and
allowance) rather than in the best interest of the firm
o Manger has the ability to operate on his own self-interest
because of IA and uncertainty (moral hazard). The manager is
the one managed the company, they know well about the
company strength and weaknesses, the uncertainty refer to
moral hazard in which the unobserved action causes the
shareholder could not identify whether the decision made by the
manager is in best interest to the principal
o Solution to the conflict of interest :
Performance based incentive plan
Performance shares, which shares given to executives on
the basis of the performance as defined by financial
measures such as EPS, ROE, ROA
Offer executives incentives to take actions to enhance
shareholders wealth.
Helps firm attract and attain managers who have ability to
performance better financial result in future
Threat of firing
Threat of takeover

Takeover occurs when inadequate management causes the


firms stock undervalued
Hostile takeover may causes the management been
dismissed by the acquired firm

b. Lending contract (bondholder and the manager)


o The bondholder is the principal and manager in behalf of
shareholder is agent
o Creditor enter contract to lend capital to the firm at rates that
are based on the riskiness of the firms existing assets, capital
structure of debt and equity financing
o The bondholders have the primary claim of the firm earnings in
the form of interest and principal payments on the debt.
However, the stockholders maintain the control of the operation
through the firms manager
o The shareholder induce management to undertake project with
great risk, the successful of the project will benefits the firms
stockholders because the creditors return are fixed,. However, if
fail, the creditor are forced to shares the losses.
o Shareholder creditor agency conflicts if shareholders attempt to
expropriate wealth from the firms creditors or take advantage
from them, creditors will protect themselves by placing
restrictive covenants in future debt agreement or charge rate
which above the market interest rate

Non-Cooperative*
The situation where players see only their own interest and thus
binding agreements among the players are not possible. Benefit get
from 1 player will as losses for the other player
Non-cooperative is very difficult to envisage a binding agreement
between manager and investor about what specific info is to be
supplied. Even the agreement is made it would be very costly to
enforced.
o Example :
Investors will desire useful tradeoffs between relevant and
reliable financial statement info, to assist in assessing the
expected values and risks of their investment. Managers,
however may not wish to reveal all the info that investors
desires, they may fear that releasing too much info will benefit
their competitors.

Corporate Social Responsibility

CSR id defined as the provision of financial and non-financial


information, as stated in corporate annual report or separate social
reports.
CSR also called corporate citizenship or sustainable responsible
business.
It involves a broad commitment by companies to social welfare. It not
only involves the products that a company manufacturers, but also
being a good corporate citizen n term of employees that it hires and
the way it looks after them.
Aims to embrace responsibility for corporate actions and to encourage
a positive impact of their activities on environment, consumers, and
stakeholders.
The purpose of CSR is to show to society about the social activities of
the corporation and its impact.
Example : donations to community group and charitable, funding
scholarship, employees training and conditions, health and safety,
product quality, consumer awards, environmental policy.

Theory of CSR
1 Social Contract
Aims to explain the boundaries of acceptable interaction
between participants within society
Represents the implicit and explicit expectations that society has
about how the organisation should conduct its operations
Traditionally the optimal measure of performance was profit
maximisation,
public
expectations
have
changed
so

organisations are now required to address human, environmental


and other social issues
Based on the idea of justice for individuals within society.
Corporate management aims to perform socially desirable
actions in return for acceptance of their entitys objectives.

2 Stakeholder Contract
All stakeholders have the right to be treated fairly by an
organisation. Management should manage the organisation for
the benefit of all stakeholders. They have a fiduciary relationship
to all stakeholders
Offered a new way to organize thinking about organizational
responsibilities.
Suggesting that the needs of shareholders cannot be met
without satisfying to some degree the needs of other
stakeholders, it turned attention to consideration beyond direct
profit maximization.
Where interests conflict, business must managed to attain
optimal balance among stakeholders.
Even when firm seek to serve its shareholders as a primary
concern, its success in doing so is likely to be affected by other
stakeholders.
When there are conflicts of interest between stakeholders, should
consider the basic needs of other stakeholders.
3 Legitimacy Contract
May be among the corporate strategy theories the closest
counterpart to the Public Relations theories
Corporate management seeks to meet societys expectations,
entitys value system aligned with the larger social system.
Legitimacy is determined to exist when the organization goals,
output, and methods of operation are in conformance with societal
norms and values.
The theory provides an explanation of managements motivation to
disclose environment information
Strategies of legitimate :
o To educate and inform relevant publics about changes in the
organizations performance and activities.
o To alter society perception towards organization action without
making any changes to that action.

o To divert or manipulate attention away from the issue concern


by the society to other alternatives issues
o To change or alter society expectations about organization
performance.
4 Institutional Contract
Provides an explanation about why organisations tend to take on
similar characteristics and form
Two main dimensions of Institutional Theory are isomorphism and
decoupling
Isomorphism refers to a constraining process that forces one
unit in a population to resemble other units that face the
same set of environmental conditions
Three different isomorphic processes
o Coercive
Arises where organisations change their institutional
practices because of pressure from those stakeholders
Example : political influence, law and regulations
o Mimetic
Organisations often copy other organisations practices for
competitive advantage and to reduce uncertainty
Without coercive pressure from stakeholders, it would be
unlikely that there would be pressure to mimic others,
hence linkage between mimetic and coercive isomorphism
o Normative
Pressures from group norms to adopt particular
institutional practices
Tend to adopt similar practicesnon-compliance could
result in sanctions being imposed by the group
5 Political economy Contract
Suggest that accounting system act as mechanism used to create,
distribute and mystify (confuse) power.
Legitimacy Theory, Stakeholder Theory and Institutional Theory
derived from Political Economy theory
Adopts a similar perspective to legitimacy theory which is respect to
the function of the annual report and a firms reason for disclosing
info.
Suggest disclosure is pre-emptive and used to stave off intervention
and the firm is an active power participant, whereas under legitimacy
theory suggests that the firm is responding to show that its actions
correspond to social expectations and reactive to social changes.

Intellectual capital
Intangible assets, trademarks, right, pattern
a Internal structure
How the company built up their intangible assets
Consist item such as patents, concept, model research which
usually created by the employees or are brought in the
company
Organization culture also considered as part of the internal
structure.
b External structure
It consists of the relationship with customers and suppliers.
How the supplier distribute their product to their customers.
c Employee competence
Refers to individuals education, skills, training and value
How does employee do their job?