Mohd Asrool Hasbullah B Shuib 1051109833 Lecture: Miss Mariati bt NorHashim Summary Normative Accounting Theory by Md. Humayun Kadir* This summary reviews Normative Accounting Theory by Md. Humayun Kadir* thats show five important works on normative accounting theory – MacNeal (1939), Paton and Littleton (1940), Litteton (1953), Chambers(1966), and Ijiri(1975) – with emphasis on recognition and measurement issues in accounting. It shows that there is a lack of agreement among these theorists on basic assumptions and hypothesized information needs of the users.
Even where there is agreement on an assumption, different implications have been drawn therefrom by the concerned theorist. These differences lead to diffrent recognition and measurement proposals. MacNeal(1939): The concept its using is a revolutionary. His work contains a vehement attack against the present accounting practice. He thinks that the function of accounting is to report economic truth. But financial statements, he argues, do not present truth. They are misleading to the investors and creditors.
In particular, he says that the historical cost principle and the conservatism convention prevent financial statements from presenting true financial position and the operating results of the firm. MacNeal evaluates three justifications offered in favor of the cost principles. 1. The cost represents the value of a fixed asset to a going concern, called ‘the going value’ theory. 2. Second, it is impractical and expensive to revalue assets every year. 3. And even if revaluations of fixed assets were done every year that would not provide significant information to the users.
He employs a deductive model. MacNeal claims that managers, creditors and stockholders want to know the present net worth of the entity. Creditors need this information because this helps them assess the probability of being repaid. Stockholders need this information because this helps them compare the possessions of their company with those of other companies whose stock they may intend to buy. Managers, creditors and stockholders are also interested in having information regarding all of the profits/losses made by the entity.
Financial statements can serve these information needs well if they report present economic values. By economic values, he means market prices established through the free play of demand and supply in a market that is free and competitive, and sufficiently broad and active. He also says that historical cost should be used only in the case of nonmarketable and nonreproducible assets. For MacNeal, it is an irony that the resulting total asset figure in the balance sheet would not make any meaningful sense since the total asset figure would be a curious mixture of market prices, replacement costs, and historical costs.
MacNeal suggests that depreciation be calculated on the present economic value of assets, rather than on their historical costs. He also defines depreciation as the loss in value of assets due to physical wear and tear. And for if the depreciation is defined as the loss in value due to physical wear and tear, it could, and should, be measured by direct reference to the market price of used asset if such price is available. It is to be noted that in that case appreciation might have to be recorded instead of depreciation. This is because the market price of used assets might exceed the original cost of the asset.
It is also to be noted that MacNeal does not allocate the market price of an asset fully as depreciation expense over its life. Its changes in market prices of assets are decomposed into depreciation expense, capital profits and capital losses. And the sum of depreciation expense,capital profits and capital losses over the whole life of an asset equal its historical cost. MacNeal says that income statement would can be include both realized and unrealized current and capital profits and losses. He suggests a form of income statement in which there are two major sections. One section reports current profits, i. . , profits from business operation and the second section reports capital profits or losses. Current profits or losses are to be closed to earned surplus and capital profits are to be closed to capital surplus. The total of profits reported in two sections would be the total net profit from all sources. And income statement designed as above would report all profits from whatever sources they may come. This would rectify the present practice of income determination. Income as presently reported is a curious mixture of realized profit and some unrealized profit and loss.
This state of income determination was responsible for the legal confusion and contradiction that existed during MacNeal’s time regarding what profit was. Attribution of the failure of the court to comprehend what accounting profit is to the accounting practice of income determination misses the important point that accounting and all of its products are social reality that must be understood in their own terms. This is because is accounting profit is self-referential. [pic] Figure 1: Structure of MacNeal’s (1939) theory
Financial statements drawn along the above lines would yield certain benefits to the users of accounting information. First, a prospective mortgagee can decide whether to lend money on a particular asset. An existing mortgagee can evaluate the safety of the loan. Second,a comparison of current assets with current liabilities would reveal the correct current ratio and liquid asset ratio that would help the business entity obtain short-term bank credit consistent with the magnitudes of the ratios. Third, the balance sheet would make large secret reserves and watered stock impossible.
Fourth, the balance sheet would reveal the amount of present capital employed. Comparison of this amount with current earnings would reveal management efficient correctly. Fifth, readers of financial statements would be made aware of changes in asset values caused by booms and depression. MacNeal also criticized present accounting practice for creating scope for income management. It is an irony for MacNeal that his proposal would not reduce that scope. The conventional argument is that reporting market prices of assets in the balance sheet would create scope for distorting financial tatements to serve managers’ self-interest unless restraints are placed as to which market prices can be used for asset valuation. Calculating present replacement cost would require a lot of judgment. Reliability of financial statements would thus be hampered. MacNeal seems a little concerned about this issue of reliability. Paton and Littleton (1940): Their attempt to develop a statement of accounting standards intended to serve as ‘guideposts to the best in accounting practice’. Methodologically speaking,P&L is a deductive work in that they base their theory on six basic assumptions.
But most of their recommendations conform to the existing accounting practice. The primary purpose of accounting is the periodic determination of income through a systematic matching of costs and revenues. Cost is the basis of recording assets, liabilities and equities and revenues are recorded at the point of sale. Thus the primary accounting report is income statement and the balance sheet is relegated to the secondary position. The purpose of the balance sheet is to report unexpired costs, not asset values. By viewing assets as unexpired costs, P&L reject the idea of incorporating periodic revision of asset values into accounts.
They also reject the conservatism convention. These are the views of P&L. P&L erect the above theory on six basic assumptions/concepts. These are (a) the business entity, (b) continuity of activity, (c) measured consideration, (d) costs attach, (e) efforts and accomplishments, and (f) verifiable objective evidence. The business entity concept says that the entity is separate and distinct from all the parties associated with the enterprise and business accounts and statements are those of the entity rather than those of the owner, creditor or any other group concerned.
One major implication of this concept is that revenues and expenses should be defined in terms of changes in enterprise assets rather than changes in owner’s equity. The second assumption, i. e. , continuity of activity, is that the business entity will continue in operation in the future. Though there are insolvency, some degree of continuity is our typical experience. Second, this assumption implies that ‘earning power’ is the most significant basis of enterprise value. The income statement is the most important accounting report.
The going concern assumption also implies that all special and non-recurring losses and gains should be included in the income statement because these items modify the long-run income stream. The activities of a business enterprise consist largely of exchange transactions with other parties. The function of accounting is to express these transactions in monetary terms. Thus,the basic subject matter of accounting is the ‘measured consideration’ involved in these transactions. Accounting undertakes to report the ‘measured consideration’, not value.
The consideration/price aggregate involved in an exchange transaction may indicate the mutual valuation at the point of transaction. In this limited sense, accounting may be said to record values. After the moment of the transaction, values may change but the recorded price aggregate does not. Accounting does not record these changes in values unless the entity is a party to the new transaction. P&L (1940) is an excellent piece of work. They are consistent in their recommendations. In recommending accounting standards, they follow the basic assumptions even if the recommendations contradict present practice.
For example, present accounting practice embodies the effects of both the proprietary view and the entity view of accounting. While we prepare accounting statements for an accounting entity (the entity view), the income statement reports net income, which is available to the stockholders, which in turn a reflection of the proprietary view. P&L adopt the entity view. This view suggests that all providers of funds be treated at par. Hence, they suggest that interest on borrowed funds be shown as a charge against income instead of revenue charge.
In other words, in P&L’s framework interest is something akin to dividend paid. [pic] Figure 2: P & L’s (1940) theoretical structure Chambers (1966): The central theme in Chamber’s system of ideas is adaptation. The assumption is that an entity wants to adapt to the prevailing market condition by engaging in exchanges. It would, therefore, want to know its stock of severable means expressed in contemporary monetary unit, because the amount obtainable from selling the assets determines and limits the entity’s scope of action in the market.
The function of accounting is to supply contemporary financial information that can act as a guide to future action. Financial position is defined ‘as the capacity of an entity at a point of time for engaging in exchanges’. It is represented by the relationship between the monetary properties of the means of an entity and the monetary properties of its obligations. Thus assets and liabilities should be reported at their current cash equivalents. This means that assets should be reported at their resale value (i. e. , realizable value) and liabilities should be reported at their present value.
However, Chambers insists on recording bonds payable at their face value and marketable bonds and other securities held as investment at market prices. Thus, liabilities and assets are accorded asymmetric treatment. Furthermore, recording bonds payable at face value contradicts Chambers’ emphasis on the entity’s adaptive ability, since if the entity wants to purchase its own bonds in the market, it would have to be pay its prevailing market price, not face amount of the bond. In Chambers’ scheme is that financial statements become allocation-free (Kam, 1990).
The depreciation expense in Chambers’ scheme is not an allocation of cost. Rather it is the decline in the market price of an asset. There is inconsistency between Chambers’ stated goal and the detailed rules he lays out for achieving that goal. For example, while he proposes that assets be shown at resale value, his proposal for inventories departs from that. Inventories should be valued at replacement cost, with resale value providing the upper limit. Fixed assets that he terms durables inventories should be reported at resale values if such values are available.
If such market prices are not available, specific index numbers be used for transforming the initial cost. Thus, as opposed to Chambers’ claim, the resulting figures of assets do not become additive. It is to be noted that Chambers criticizes historical cost accounting as resulting asset figures that are not additive. This is because asset figures in the balance sheet are historical costs of different dates. [pic] Ijiri (1975): He is an inductivist. Ijiri theorizes conventional historical cost accounting and is a staunch supporter of the historical cost principle.
On the one hand, he develops three axioms from which, he claims, conventional accounting practice can be derived. On the other hand, he offers justifications in favor of this principle. The three axioms are as follows (Ijiri 1975: 74): Axiom of Control: The set of all resources under the control of an entity at time t can be identified uniquely at that time or later. Axiom of Quantities: All resources under the control of an entity at time t can be uniquely partitioned into classes of resources at that time or later in such a way that for each class a nonnegative and additive quantity measure is defined.
This measure has the property that two sets of resources in the same class are treated as being substitutable in the uses of the resources if and only if their quantities are the same. Axiom of Exchanges: Every change in the set of resources under the control of the entity can be classified uniquely as it occurs either as terminator of an old simple exchange or an initiator of a new simple exchange with an estimated terminator. To Ijiri, the above axioms are analogous to the five axioms of Euclidean geometry from which all theorems in Euclidean geometry can be derived.
Ijiri claims that present accounting practice can be derived from the above three axioms. Once the three judgements are made, what remain in accounting are merely computational procedures. As we know, Ijiri is an inductivist. He inductively derives the goal implicit in current accounting practice and uses this goal to suggest improvements in practice. In inducing the goal, he emphasizes the fact that accounting records every transaction. The rationale of this practice, he argues, is that the accountee is accountable for every transaction.
He further claims that in a business in which outsiders invest, a manager maintains accounting records not because he expects to use them in internal decision making, but because he expects the records to generate useful information for use by the investors. Thus, he tells us, the goal underlying present accounting practice is accountability. Accounting facilitates the smooth functioning of ‘accountability relationships among interested parties’ (Ijiri 1975: ix, italics in original). And, it is accountability that distinguishes accounting from other information systems in an organization or a society.
This is the basic viewpoint of Ijiri (1975). Historical evidence does not lend support to Ijiri’s claim that a business manager maintains accounting records primarily for the outside investors. The generation of huge accounting and other operating data within the American railroad business during their early years during the nineteenth century was driven mainly by the internal information needs of the railroad managers (Chandler 1977). Accountability is one such important perspective on accounting. Ijiri distinguishes his approach from the decision usefulness approach along the following three dimensions:
First, the decision usefulness approach emphasizes the output of the accounting system, i. e. , financial statements. The accountability view stresses the system behind the financial statements. Second, the accountability view anticipates the pressure to bias accounting information and emphasizes the establishment of a system that is strong enough to withstand such pressures. Third, the accountability view treats the accounting system as the equilibrium outcome of the accountor-accountee relationship. Three parties are involved in an accountability relationship: accountee, accountor, and accountant.
The accountability relationship normally requires the accountor to account to the accountee for his (accountor’s) activities and the consequences thereof. The accountor keeps detailed records for the benefit of the accountee. An accountant joins this relationship as a third party. He helps the accountor to account for his activities and supplies information to the accountee. Ijiri (1975) thus treats the accountee and the accountor symmetrically (Sunder1997: 6). In an accountability relationship, the accountor is responsible to the accountee for the achievement of the goals assigned to the accountor.
Information on the accountor’s progress toward the achievement of the goals must be supplied to the accountee. The key issue in accounting is, thus, ‘measurement of the economic performance of the accountor’ (Ijiri 1975:ix, italics in original). The accountability view should be the basis of flow of information from the entity to the users. He emphasizes the accountee’s ‘right to know’. The purpose of the introduction of this concept in Ijiri’s scheme seems to limit the users who are entitled to have information from the entity. 8 However, Ijiri’s purpose of limiting the recipients of accounting information is not served by the concept ‘right to know’ due to the broad basis of accountability. ‘The accountability relationship may be created by a constitution, a law, a contract, an organization rule, a custom, or even by an informal moral obligation. A corporation is accountable to its shareholders, creditors, employees, consumers, the government, or the public in general based on a variety of relationships created between them’ (Ijiri 1975: ix).
This quotation indicates that virtually everybody has the right to know from the entity. We have noted that Ijiri is a strong supporter of the historical cost principle. He offers three major justifications in favour of this principle. First, the proper functioning of accountability rests on proper records of past activities. And, the historical cost principle requires the recording of all actual transactions. Second, this principle yields the most useful performance measure. Other bases of measurement such as net realizable value and replacement costs may be useful to some decisions.
Ijiri rejects these bases for continuous recording on the ground that these bases are based on actions (i. e. , selling and buying at the balance sheet date) that entity normally does not intend to undertake. Thus, he invokes the going concern assumption here. Ijiri says that value is two-dimensional concept. These are sacrifice value and benefit value. Ijiri opts for the sacrifice value i. e. , historical cost on the ground of hardness of the measure. Third, historical cost is useful to economic decisions in general. [pic]