Tutorial Questions
Define ‘relevance’ and ‘reliability’. Is there a trade-off between the two?
According to the Accounting Framework in Fiji, an item of information is relevant if it is likely to influence users’ resource allocation decisions. An item of information is reliable if it faithfully represents, without bias, a particular transaction
There is normally considered to be a trade-off between relevance and reliability. For example, historical cost information may be particularly reliable, but for many decisions it may not be particularly relevant. Current market value data may be particularly relevant for particular decisions (for example, in relation to a decision about selling an asset), but what management thinks the item is currently worth will not ultimately be known until disposal. That is, the reliability of the information may not be clear. This may be the case particularly for the market valuations attributed to unique and thinly traded assets.
Further, financial statement data is typically audited prior to distribution. This may take many weeks. The data becomes more reliable as a result of the audit but, being less timely, it becomes less relevant for current investment decisions.
With all the regulations that companies must follow, fulfilling the requirement for corporate reporting is an additional reporting activity. What are the some possible arguments for and against these regulations?
This question may be answered in terms of a ‘free market’ versus a ‘regulated’ argument about the provision of accounting information.
Many academics argue in favour of a free-market approach. By this, we mean that the market forces of supply and demand should be allowed to operate freely to determine the equilibrium amount of accounting information to be provided. This argument holds that if the users of accounting reports demand information, but it is not being supplied, this will be priced into the amount they will charge the firm for the factors of production they supply to the firm (for example, equity capital). If an individual is able to obtain the demanded information this may lead them to reduce the risk they attribute to the investment, which may translate into a lower required return on their investment. In a sense, the price they pay for the information is the reduction in required return they demand as a result of being provided with the information (which reduced their risk). The firm is predicted to supply information to the point where the benefits of providing the information (perhaps in terms of lower cost of capital) equals the costs of providing the information—which, of course, assumes that the managers of an organization have quite a sophisticated grasp of market economics. It has also been argued by proponents of the free-market argument that because there will often be conflict between the various parties associated with an organization (for example, owners and managers), accounting reports will be produced that are designed to minimize the conflict and the associated costs of the conflict. It has also been argued that managers are best placed to select accounting methods that best reflect the financial performance and position of their particular organization, and so it is inappropriate and inefficient to impose regulation upon them that restricts the accounting methods they might choose to use.
The argument is also made that in the absence of regulation, organisations would still be inclined to disclose information in case various external parties take their silence to mean that the entity has something to hide (the ‘market for lemons’ argument).
Advocates of a regulated approach would argue that a free-market approach is flawed for a number of reasons. First, the producers of the information cannot typically control its dissemination. Parties such as competitors, analysts and the like will obtain the information, but will not directly pay for it (they are deemed to be ‘free riders’). The free-rider problem may, in an unregulated environment, lead to a reduction in the supply of information owing to an understatement of demand. Further, although in the long run market forces may operate, it may be that organizations have created significant social costs in the mean time. For example, the disclosure of environmental information—that is, pollution emissions, clean-up costs, etc.—are not currently required in New Zealand. Research evidence suggests, however, that there are many accounting report users who may be interested in such information (for example, to assess the appropriate risk rates). It may be that sooner or later the market will punish those firms that do not provide information (in the absence of information the market may assume that there is bad news to report); however, significant costs may have been imposed on society by this time.
The free-market approach to financial reporting also ignores issues associated with stakeholders’ right to know about certain aspects of an entity’s operations. Stakeholders without financial resources (and perhaps the power to demand financial information) may simply be ignored in the information dissemination process, yet they may nevertheless be impacted on by the operations of the organization. Introducing regulation might also have the effect of increasing confidence in the capital markets, which might be construed as being in the public interest.
Define Generally Accepted Accounting Practice.
Generally Accepted Accounting Practices (GAAPs) are those rules and practices that have changed and developed over time and are accepted at a point of time by the majority of accountants. Across time, Generally Accepted Accounting Practices become incorporated within Accounting Standards, with Accounting Standards being developed through a consultative process in which many parties from Australia and elsewhere give their viewpoints through formal submissions and other avenues. Accounting Standards constitute a subset of GAAPs.
What is the role of the independent auditor, and why would the manager or the users of financial
statements be prepared to pay for the auditor’s service?
The auditor acts as an independent reviewer of the financial accounts presented by a reporting entity. Being independent, the auditor is expected to provide an objective assessment of whether, in the auditor’s opinion, the accounts have been prepared in conformity with the various accounting and other reporting rules applicable to the reporting entity. The auditor, in a sense, gives greater credibility to the financial statements and allows financial statement users to rely upon the statements with greater confidence. With greater confidence, the financial statement users may attribute lower risk to a reporting entity, and this in turn may lead to the reporting entity being able to attract funds at a lower cost than may otherwise be possible. So although the reporting organization will have to pay for the audit, the benefits of attracting greater funds at a lower cost (because of a perception that the information about the organization is more reliable or credible) could more than outweigh the costs associated with the audit. In this regard it should be noted that prior to the introduction of legislation that required certain forms of organizations to have their financial reports audited, many organizations chose to have their financial reports audited because of the perceived benefits. Where there are perceived conflicts of interest between different parties within the organization (for example, between owners and managers) the auditor can act to arbitrate on the reasonableness of the accounting rules and assumptions adopted by the managers.
With this said, it should also be emphasized that an unqualified auditor’s report does not give assurance that all transactions have been correctly accounted for, or that the entity is assured of being viable in the future. Also, it is conceivable that the credibility of all audit firms will not be deemed to be the same, so that if financial statement users consider that an auditor is of low ‘quality’, an audit report produced by such an auditor may be of limited value. Lastly, it should be stressed that the preparation of the financial reports is the responsibility of management and the auditor will not make any changes to those reports: the auditor’s role is to give an opinion on the reports (for example, that they are true and fair and comply with applicable Accounting Standards).
Define ‘relevance’ and ‘reliability’. Is there a trade-off between the two?
According to the Accounting Framework in Fiji, an item of information is relevant if it is likely to influence users’ resource allocation decisions. An item of information is reliable if it faithfully represents, without bias, a particular transaction
There is normally considered to be a trade-off between relevance and reliability. For example, historical cost information may be particularly reliable, but for many decisions it may not be particularly relevant. Current market value data may be particularly relevant for particular decisions (for example, in relation to a decision about selling an asset), but what management thinks the item is currently worth will not ultimately be known until disposal. That is, the reliability of the information may not be clear. This may be the case particularly for the market valuations attributed to unique and thinly traded assets.
Further, financial statement data is typically audited prior to distribution. This may take many weeks. The data becomes more reliable as a result of the audit but, being less timely, it becomes less relevant for current investment decisions.
With all the regulations that companies must follow, fulfilling the requirement for corporate reporting is an additional reporting activity. What are the some possible arguments for and against these regulations?
This question may be answered in terms of a ‘free market’ versus a ‘regulated’ argument about the provision of accounting information.
Many academics argue in favour of a free-market approach. By this, we mean that the market forces of supply and demand should be allowed to operate freely to determine the equilibrium amount of accounting information to be provided. This argument holds that if the users of accounting reports demand information, but it is not being supplied, this will be priced into the amount they will charge the firm for the factors of production they supply to the firm (for example, equity capital). If an individual is able to obtain the demanded information this may lead them to reduce the risk they attribute to the investment, which may translate into a lower required return on their investment. In a sense, the price they pay for the information is the reduction in required return they demand as a result of being provided with the information (which reduced their risk). The firm is predicted to supply information to the point where the benefits of providing the information (perhaps in terms of lower cost of capital) equals the costs of providing the information—which, of course, assumes that the managers of an organization have quite a sophisticated grasp of market economics. It has also been argued by proponents of the free-market argument that because there will often be conflict between the various parties associated with an organization (for example, owners and managers), accounting reports will be produced that are designed to minimize the conflict and the associated costs of the conflict. It has also been argued that managers are best placed to select accounting methods that best reflect the financial performance and position of their particular organization, and so it is inappropriate and inefficient to impose regulation upon them that restricts the accounting methods they might choose to use.
The argument is also made that in the absence of regulation, organisations would still be inclined to disclose information in case various external parties take their silence to mean that the entity has something to hide (the ‘market for lemons’ argument).
Advocates of a regulated approach would argue that a free-market approach is flawed for a number of reasons. First, the producers of the information cannot typically control its dissemination. Parties such as competitors, analysts and the like will obtain the information, but will not directly pay for it (they are deemed to be ‘free riders’). The free-rider problem may, in an unregulated environment, lead to a reduction in the supply of information owing to an understatement of demand. Further, although in the long run market forces may operate, it may be that organizations have created significant social costs in the mean time. For example, the disclosure of environmental information—that is, pollution emissions, clean-up costs, etc.—are not currently required in New Zealand. Research evidence suggests, however, that there are many accounting report users who may be interested in such information (for example, to assess the appropriate risk rates). It may be that sooner or later the market will punish those firms that do not provide information (in the absence of information the market may assume that there is bad news to report); however, significant costs may have been imposed on society by this time.
The free-market approach to financial reporting also ignores issues associated with stakeholders’ right to know about certain aspects of an entity’s operations. Stakeholders without financial resources (and perhaps the power to demand financial information) may simply be ignored in the information dissemination process, yet they may nevertheless be impacted on by the operations of the organization. Introducing regulation might also have the effect of increasing confidence in the capital markets, which might be construed as being in the public interest.
Define Generally Accepted Accounting Practice.
Generally Accepted Accounting Practices (GAAPs) are those rules and practices that have changed and developed over time and are accepted at a point of time by the majority of accountants. Across time, Generally Accepted Accounting Practices become incorporated within Accounting Standards, with Accounting Standards being developed through a consultative process in which many parties from Australia and elsewhere give their viewpoints through formal submissions and other avenues. Accounting Standards constitute a subset of GAAPs.
What is the role of the independent auditor, and why would the manager or the users of financial
statements be prepared to pay for the auditor’s service?
The auditor acts as an independent reviewer of the financial accounts presented by a reporting entity. Being independent, the auditor is expected to provide an objective assessment of whether, in the auditor’s opinion, the accounts have been prepared in conformity with the various accounting and other reporting rules applicable to the reporting entity. The auditor, in a sense, gives greater credibility to the financial statements and allows financial statement users to rely upon the statements with greater confidence. With greater confidence, the financial statement users may attribute lower risk to a reporting entity, and this in turn may lead to the reporting entity being able to attract funds at a lower cost than may otherwise be possible. So although the reporting organization will have to pay for the audit, the benefits of attracting greater funds at a lower cost (because of a perception that the information about the organization is more reliable or credible) could more than outweigh the costs associated with the audit. In this regard it should be noted that prior to the introduction of legislation that required certain forms of organizations to have their financial reports audited, many organizations chose to have their financial reports audited because of the perceived benefits. Where there are perceived conflicts of interest between different parties within the organization (for example, between owners and managers) the auditor can act to arbitrate on the reasonableness of the accounting rules and assumptions adopted by the managers.
With this said, it should also be emphasized that an unqualified auditor’s report does not give assurance that all transactions have been correctly accounted for, or that the entity is assured of being viable in the future. Also, it is conceivable that the credibility of all audit firms will not be deemed to be the same, so that if financial statement users consider that an auditor is of low ‘quality’, an audit report produced by such an auditor may be of limited value. Lastly, it should be stressed that the preparation of the financial reports is the responsibility of management and the auditor will not make any changes to those reports: the auditor’s role is to give an opinion on the reports (for example, that they are true and fair and comply with applicable Accounting Standards).
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