Week 7 tutorial questions and solution (to be discussed in week

9):

Suggested Solutions to tutorial 9 questions from Chapter 1

(Please note that these answers are only hints. Students are
strongly encouraged to add your own points, examples and other
information that were discussed in the tutorials. Students are
also encouraged to add information from their reading of the
text book or other journal articles)

Discussion questions (DQ): 1.3 1.9, 1.11, 1.18, 1.24 and 1.30.

Additional question (AQ): 1.32.

Critical thinking (CT) question: 1.2:

1.3. What is a conceptual framework, and would it be a positive or normative

theory of accounting?

Answer: A conceptual framework, such as the International Accounting Standards

Board (IASB) Conceptual Framework for Financial Reporting, provides some
fundamental assumptions about the role of general purpose financial reporting and the
attributes that financial information should possess for it to be useful in assisting the
resource allocation decisions of financial statement readers. As indicated in this chapter,
the United States’ Financial Accounting Standards

Since conceptual frameworks provide perspectives about such issues as: the qualitative
characteristics that financial information should possess; the identification of the types
of entities that should produce general purpose financial reports; the way in which the
elements of financial accounting should be defined and recognised, and so forth (note
the emphasis on ‘should’), the conceptual frameworks—in providing prescription—
are considered to be normative in nature. Positive research, on the other hand, might
simply attempt to describe or predict the behaviour of those people in charge of
producing general purpose financial reports, or the behaviour of financial report readers

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 1.9 Is the study of financial accounting theory a waste of time for
accounting students ? Explain your answer.
Answer:
 The outputs of the accounting system are used in many decisions throughout
society and hence it is important to consider how particular accounting methods,
or changes thereto [e.g. impact on contract or agreements according to Positive
Accounting Theory (PAT), or share prices according to Capital Market Research
(CMR)], will impact various groups.
 If we only considered how to calculate accounting numbers, without considering
their impacts, then we would be only getting a fraction of the total ‘story’.
 People involved in accounting logically need to have some perspective about
how people will react to different accounting numbers or forms of disclosure
[again CMR, Behavioural Research (BR) or Systems Theories]. Accounting
theories can provide us with such insight.
 People involved in accounting should arguably understand the different factors
which might have influenced accounting standard-setters when they developed
particular requirements (e.g theories on regulation give insights on this issue).
 There are various perspectives about why organisations might adopt particular
accounting methods (PAT). If we are ultimately involved in reading financial
statements, then understanding the possible motivations of those in charge of
preparing the financial statements will be useful. Such insights might be useful
when interpreting particular accounting disclosures. If we do not read about
accounting theory then these insights might not be available to us.
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What is the difference between developing a theory by induction and developing a

theory by deduction ? Critically analyse both approaches.
In the Inductive approach, undertaking research based on observing actual
practice provides an understanding of what is being done in accounting practice.
Although a key point here is - what we observe to be happening, and what we
record, might be influenced by our own values and biases that we have prior to
undertaking the research. This means that researchers with different ‘views of the
world’ (perhaps they work from quite different research paradigms) might

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 actually see things differently; ask different questions and record different events
than would other researchers. Inductive researchers need to be careful that their
own biases do not overly influence the data they are collecting if they are
attempting to develop a theory based on actual practice. With the above in mind
we can argue that it is important to understand current practice and therefore
inductive research provides an important basis for subsequently providing
suggestions for improvement to practice.

However, if we restrict our research to describing what currently occurs, this in

itself does not allow us to evaluate the practice or to prescribe improvements. For
example, just because most accountants do things in a certain way – which would
be identified by inductive research – this does not in itself mean that it is the
best way to do things. We also need to suggest ways of improving practice. That
is why, we need deductive reasoning as well. Using deductive reasoning, we
draw conclusion based on premises, which prescribes events,
accountants/auditors’ behaviours. Using deductive approach, we find some
framework/guidelines for behaviours from different actors in the business. By
following these guidelines, managers, accountants, auditors should work.
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1.18 What is a paradigm, and would you expect accounting researchers to
embrace more than one paradigm when understanding research? Explain
your answer.
Answer:
(One definition of a paradigm). According to Hussey and Hussey (1997, p.47):
The term paradigm refers to the progress of scientific practice based on
people’s philosophies and assumptions about the world and the nature of
knowledge; in this context, about how research should be conducted.
Paradigms are universally recognised scientific achievements that for a time
provide model problems and solutions to a community of practitioners. They
offer a framework comprising an accepted set of theories, methods and ways
of defining data … Your basic beliefs about the world will be reflected in the
way you design your research, how you collect and analyse your data, and
even the way in which you write your thesis.

Kuhn (1962) also provided another definition of a paradigm. He stated that ‘a

paradigm can be defined as an approach to knowledge advancement that adopts

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particular theoretical assumptions, research goals and research methods’ (cited
from Deegan, 2014, p. 14). One’s own values will impact the research paradigm
they elect to embrace.

In terms of whether researchers would typically embrace more than one paradigm
when doing research, the general answer would be no (although there are some
limited exceptions to this).

The paradigm a researcher embraces is impacted in large part by their own values
and beliefs, hence often researchers would feel uncomfortable embracing more
than one paradigm. For example, if I strongly disagreed with a perspective that
all individual action is driven by self-interest then I would not feel comfortable
embracing a paradigm—such as Positive Accounting Theory—that embraces as a
core assumption the view from neo-classical economics that individuals are
principally motivated by self-interest.

Similarly, if I believed that it is inappropriate to treat all organisations as being

homogeneous (that is, as being the same) then I would adopt a research
paradigm that perhaps relied upon in-depth case study research, rather than large
scale research undertaken by way of mail-out questionnaires, or research that
utilised secondary data, such as details of share-price movements of many
companies.

(However, if students believe as I do that researchers can adopt complimentary

approaches then you can give justification for that and you don’t have to be
restricted by the above viewpoint).
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1.24: Identify five different criteria that we might use to evaluate a theory
as being suitable for our research.
Answer:
Whether we think a particular theory is a ‘good theory’ or not will often be very
much a subjective assessment (although a poorly developed theory should be
rejected by all researchers). Some criteria that we might use to evaluate a theory

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 as appropriate for our own use (and a number of these criteria overlap) include
the following (and although the question has asked for five criteria I have
provided more):

A number of issues are considered in determining whether a particular theoretical

perspective is sound or not.
 How logical does it appear? Is it possible to break the major views of a theory
up into main premises, and do the premises, when viewed together, seem to be
logical?

The argument will be logical to the extent that if the premises upon which the
theory or argument is based are true, then the conclusion will be true.

 When considering the logic of the argument we must be careful to consider

whether our acceptance of an argument has been influenced by any emotive
or colourful language that has been used.

 Are the underlying assumptions adopted within the theory realistic? If the
assumptions appear to conflict with how we see the world, then we may
tend to reject the theory.

If the logic of the argument appears to be based on some key assumptions, are we
prepared to accept these assumptions? Whether we accept particular assumptions may
be based on whether the assumptions themselves appear reasonable.

 Does the theory tie in well with our own perspectives of what ‘theory’ should
achieve? For example, if we think that theory should be capable of generating
generalisable predictions, then does the theory in question do this?

 Whether we accept a particular theory might also be dependent upon whether it

appears to be superior to existing theories in terms of explaining particular
phenomena (if we are applying positive theories).

 We may reject a theory because we consider that the underlying assumptions do

not tie in with our own value systems.

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 Was the theory developed by well-respected researchers? This will provide some
comfort, however we must remember that everybody will get it ‘wrong’ at some
stage.

Whilst this is comforting, particularly if many research studies have generated

results that support the theory, it needs to remember that just because a lot of
people are doing something does not necessarily mean it is the ‘best’ way to do
something.
 Is the theory parsimonious? That is, compared to other theories that provide
similar insights, is our theory simpler to understand?
 Is the theory falsifiable? That is, according to some researchers (the
‘falsificationists’) a ‘good theory’ is one that can produce predictions that have
the potential to be disproved.
 Also, at a pragmatic level, if we use one theory in preference to another, will this
impact the possibility of getting the research published? (While it could be
argued that such considerations of ‘publishability’ should not be relevant, and
they certainly deviate from the issue of whether we evaluate a theory as being
‘sound’, in practice promotion within an academic career is typically based on
issues such as number of publications, and hence such concerns can be very real.
Further, it is generally accepted that it is easier to get research published if it
follows existing theories, rather than relying upon a newly developed theory.

 Have the proponents of a theory provided evidence to support it? Are we

satisfied with the evidence presented, and the way it has been collected?
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1.30: What is hypotheses? Do you think that accounting researchers should

be involve the development of hypotheses?
 A hypothesis can be defined as a proposition, typically derived from theory,
which can be tested for causality or association using empirical data.
 Hypotheses often act to provide predictions that can then be empirically
tested.
 For much normative research there is not an intention to explain or predict
current practice, hence the development of empirically testable hypotheses

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 would not necessarily be appropriate. Nevertheless, normative research has
the potential to provide valuable insights into improving the practice of
accounting.

 Whilst hypotheses are often developed within positive research that utilises
large amounts of observations (for example, thousands of observations of
movements in share prices),

 For researchers who seek to develop ‘rich insights’ from case study research,
it is generally accepted that the use of hypotheses is not appropriate. Further,
if a researcher adopts a view that suggests that all organisations and
individuals are fundamentally different, then such a researcher would not
tend to develop hypotheses to test across a broad range of individuals or
organisations.

 By contrast, a researcher who adopts an assumption that all individuals are

motivated by self interest might be inclined to develop hypotheses for testing
across different samples of the population.

What is being emphasised here is that the absence of empirically testable

hypotheses does not necessarily negate the value of particular research.

Suggested dot point answers to additional questions:

1.32: If a researcher tested a theory on a particular sample of companies, what

considerations would you examine before you would agree with the
researchers that results can be generalised to the larger populations of
companies ?

Of importance is how the sample was selected. Generally speaking, to

generalise the results of a particular sample to a larger population the sample
must be representative of that larger population. This will usually require that the
sample was of a reasonable size and that the selection process was of a random
nature, such that each item in a population has an equivalent chance of being
selected. If a sample is not randomly selected then any efforts at generalising
will commonly be criticised.

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 When selecting a sample it is also important that the items in the
‘population’ have similar attributes (which in itself is the essence of a
‘population’). Some researchers from more of an ‘interpretive’ perspective
question whether different organisations are actually that similar. They consider
that because of differences in personalities, social and organisational structures
and cultures, institutional influences, and so on, then large scale research (which
relies on sampling) is inappropriate because it is not valid to generalise across
organisations, that in essence, are very different. Researchers working within an
‘interpretive paradigm’ generally do small-scale, in-depth research.
-----------------------

DQ7.4: Explain the management bonus hypotheses and the debt hypothesis of
Positive Accounting Theory.
Answer:
Managers are often rewarded in terms of accounting-based bonus plans. Such
plans are introduced to align the interests of the managers of the firm with those
of the owners. The establishment of management bonus plans can be explained
from an efficiency perspective. The management bonus plan hypothesis
predicts that managers who are rewarded in terms of accounting numbers are
more likely to select accounting methods that increase income to the extent that
this will lead to an increase in the size of the bonus. This is an opportunistic
perspective. The efficiency perspective relates to the initial establishment of the
bonus scheme and the opportunistic perspective relates to the subsequent efforts
to manipulate profits and hence, the bonus.

The debt hypothesis (also called the debt/equity hypothesis) predicts that firms
with higher debt/equity or debt/assets ratios are more likely to adopt accounting
methods which increase income (and assets and residual equity) than firms with
lower ratios. This prediction is made on the basis of an assumption that firms
will have entered into debt contracts with external lenders (with the purpose of
reducing agency costs and hence explained from an efficiency perspective) and
these debt contracts will rely upon accounting numbers. The incentive to
adopt income increasing methods will increase the closer the firm comes to
breaching the accounting-based debt covenant. While debt contracts will
initially be entered into in an endeavour to reduce the costs of borrowing (the

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 efficiency perspective), the view that management will subsequently choose
‘favourable’ methods to loosen the restrictions imposed by debt-related
contractual covenants is considered to represent an opportunistic perspective.

7.7: What is an agency relationship and what is an agency cost ? How

Can agency costs be reduced?

An agency relationship occurs when decision-making authority is delegated from one

party (the principal) to another party (the agent). Jensen and Meckling (1976,
p.308) define the agency relationship as:

a contract under which one or more (principals) engage another person (the agent)
to perform some service on their behalf which involves delegating some decision-
making authority to the agent

From the Agency Theory perspective, the ‘contract’ itself does not need to be
written. Because it is assumed that all individuals will act in their own self-
interest, there will be costs (agency costs) associated with appointing agents to
make decisions on behalf of the principals. Agency costs can be defined as costs
that arise as a result of the agency relationship and relate to the costs that arise as
a result of the process of delegating decision making to others.

Based on the Agency Theory, it is argued that various contractual arrangements

will be put in place to minimise anticipated agency costs and hence to
increase the value of the organisation. For example, to minimise the agency
costs relating to appointing a manager, contractual arrangements might be put in
place to provide the manager with a share of profits. That way, the manager will
be motivated to make decisions that lead to an increase in profits and, all things
being equal, this will also be in the interests of the owners.

An organisation is considered to represent a nexus of contracts between many

self-interested individuals and the reason for having the various contracts is to
reduce the agency costs that the organisation might otherwise encounter and
consequently to maximise the expected value of the organisation.

7.8. Explain the political cost hypothesis of Positive Accounting Theory.

Answer:
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 Political costs are those costs that particular groups external to the firm may be
able to impose on the firm as a result of various actions. For example, the costs
associated with the community lobbying the government to decrease the subsidy
support for an organisation, the costs associated with labour unions taking
actions to increase the wages of their members or the costs associated with
consumer boycotts associated with the firm’s products.

The political cost hypothesis predicts that those organisations under political
scrutiny (usually assumed to be larger firms) will undertake actions to minimise
the possibility of adverse cash flows associated with the scrutiny. For example,
if a company is being scrutinised in a particular period because of its perceived
monopoly powers and those external parties undertaking the scrutiny claim that
these monopoly powers enable it to generate excessive profits, then in such
periods the entity may elect to adopt accounting methods which reduce its
reported profits, and hence, its susceptibility to actions to reduce the wealth of
the organisation (perhaps, in the form of increased taxes). Watts and
Zimmerman provide the following explanation of the political cost hypothesis:

The political cost hypothesis predicts that large firms rather than small firms are
more likely to use accounting choices that reduce reported profits. Size is a proxy
variable for political attention. Underlying this hypothesis is the assumption that it
is costly for individuals to become informed about whether accounting profits really
represent monopoly profits and to ‘contract’ with others in the political process to
enact laws and regulations that enhance their welfare. Thus rational individuals are
less than fully informed. The political process is no different from the market
process in that respect. Given the cost of information and monitoring, managers
have incentive to exercise discretion over accounting profits and the parties in the
political process settle for a rational amount of ex post opportunism (1990, p.139)

As reflected in the above quote, the political cost hypothesis assumes that various
parties will simply react to the quantum of reported profits and will not necessarily
focus on which accounting methods were used to generate these profits.

In the class lecture, we discussed that CBA cuts more than 1000 job in the day they declared
recorded 2.6 billion $ profit (page number 311 Accounting Headlines 7.5). This example is relevant
here.

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 Students Critical thinking question: 7.19.

Assume that Kahuna Company limited decides to undertake an upward revaluation of

its non-current assets just prior to the end of financial year, the effect being that the total
assets of the company increase, as does total stakeholders’ equity.
(a) Explain the decision of management to undertake an asset revaluation in terms of
debt hypothesis of Positive Accounting Theory.
(b) Explain the decision of management to undertake an asset revaluation in terms of
management bonus hypothesis of Positive Accounting Theory.
Answer:
First, students should try this question to answer either individually or group as no
answer will be provided. we may discuss the answer of this question in the tut.

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