Accounting Theory

The paper explores public interest theory, private investment theory and regulator capture theory. After this our paper focusses on three key accounting areas. These areas are capital budgeting, capital structure and various investments made by the company. This will help us evaluate how the structure of accounting helps in these public disclosures. We also look into General Purpose Financial Reporting (GPFR) and whether at it is important for accounting world. In our analysis we came out with a conclusion that GPFR is actually important, because its keeps all the stakeholders of the current condition of the company.

Introduction In this paper we look at various theories about accountancy. We also look at how these theories have shaped up the accounting world. We analyses this on the basis of few critical business decisions. These decisions are capital budgeting, capital structure & various investments based by the company. We have chosen these three areas on our paper as these are the ones which are very critical to any business decision in the financial world. These three factors impact the accounting and its methodology the most. We also have a look at GPFR (general purpose financial reporting).

This gives us the insight whether at all GPFR is necessary in business world. (Harris, 1998) Theories of Accounting Public Interest Theory Public interest theory of accounting is concerned with achieving desired financial results which the majority of the public wants the firm to achieve. Generally these results are not achieved as no firm is free of markets. It is the set of market inefficiencies which cannot be solved by regulators that does not help the case of the firm’s commitment to achieve desired financial results. Private Interest Theory

Private Interest theory of accounting is concerned with achieving financial results which the private sector or private group of individual wants to achieve. This is something which generally happens but the regulators are looking at methods to stop it. They want to stop it because this will be bad from the shareholders perspective. Regulatory Capture Theory Regulatory capture theory helps in managing the accounts on the basis of the regulators of accounts of the company. This is actually the way the corporate structure and the regulators work together.

This framework helps in establishing the real accounting world and its controls. Is accounting Needed (GPFR)? It is very important that GPFR takes place otherwise all the stakeholders will never know about the performance of the company. Many predictions required for a serious analysis of an investment cannot only be done by the authority of the financial function (financial department or, management controller). That must be made by departments which are directly concerned by the project, with necessary information (sales department, production or scheduling).

At this level, the role of the financial department is simply to force the relevant departments to provide forecasts expressed in monetary terms in time. (Harris, 1998) Once in possession of all required information, the financial function analyzed in depth it in order to quantify the financial impact, to calculate the total cash flow forecasts and if the project is likely to be released. Various rates of return and various dead spots are also determined and calculated. Another task of the finance function is to explain clearly the financial strain that the company is subjected to.

In other words, they measure the volume of financing, if the company is able to implement and ensure the implementation of the proposed investments (equity, bank loans, leasing) What does the financial department (accounts) do? The financial department finally makes a coherent synthesis of all proposed projects and provided funds by establishing an investment and financial plan. Usually, the first draft plan shows a lack of funding and it is the general direction that then takes a definitive decision depending not only on profitability but also on other constraints such easily measurable that risk, the urgency, necessity, or prestige.

Even if the financial function is closely associated with the work of balancing the investment plan and financing, the decision is necessarily and ultimately up to the general direction. (Harris, 1998) Why public disclosure became so serious? If the interest of organisation and individuals are not aligned then there are classical cases like Arthur Anderson and Enron comes up in the public world. This case tries to highlight how a corporation like Arthur Anderson came to such demise. 80 years of legendary innovative history in Corporate America that was created by Arthur Anderson was washed up in a matter of 8 years.

Internal divisions came up in the company and the world started to look at Corporate America with shame. To align the principal agent theory in practice, Sarbanes Oxley came into operation in 2002. The act tried to align the best interest of the shareholders and the agent i. e. Management in the same mould. The objective of the act was to reduce the ever growing gap between the two of the main functions of the organisation. Principal Agent Outlook There are two main functions of any organisation which decide the fate of the organisation as a whole.

The first one of them is the shareholders (Principals) who elect the Management (agent) to represent them as the owner of the company. The objective of the principal is to maximise shareholders wealth while that of Management can be the same or it can be different also. If the objectives are aligned by using good compensation strategy and urging responsibilities over the management then agency cost of the company will be reduced. If that is not the case agency cost will always increase. (Harris, 1998) With this background let us have a look at the classic case of Arthur Anderson.

Management of the company which was looking after the AA division of the company was less compensated compared to their counterparts in AC. This is itself a contradiction to the principal agent theory. Arthur Anderson has grown from the roots as a major auditor and the consulting division came into picture very late when they started automating the book keeping systems. AC was very successful and the compensation was not in alignment with the kind of success they achieved. Hence the companies were separated and consulting division was now separate from auditing division.

After the separation AC kept growing fast with their own set of compensation strategy while AA started facing challenges. These challenges are advent from the number of lawsuits AA faced during 1990s and 2000. Employees at AA were resenting and finding other ways to get paid and rope in extra money for the organisation and themselves. This is when they started realigning shareholders interest with theirs. This was visible in the biggest corporate scandal of America- Enron. Enron was the worst corporate scandal which shook American Corporation.

Auditors at Arthur Anderson signed the financial statements of Enron without cross checking the stated facts. This was done just to rope in extra money from this big ticket client. Somewhere this is an also a case where organizational structure should be questioned. The reason for this is because for a big ticket client like Enron, Arthur Anderson compromised its corporate hierarchy. They allowed their premier groups to go and reside at the client’s headquarter. There was no proper check on what was happening within employees and the client. Principal agent theory can be used to understand the situation.

If a shareholder tries to give management major go ahead with all the decisions it needs to compromise authority. Now if the same owner tries to keep a check on Managements work policies and decision, it needs to inculcate huge agency cost. Before 2002 this was all trust based system. After Arthur Anderson and Enron Scandal which shook America, Corporations started looking into aligning the compensation strategy in a manner which will make sure that management works in the best interest of the shareholder. Agency Cost- Critical Reason for accounting frauds

It is very critical for any firm to align its softer and harder corporate culture so that the synchronization helps in the growth of the culture of the firm. The rigidity of firms such as Arthur Anderson in the culture was compromised in 1990s with new management thinking and policies and the result of the same is a classic failure. Arthur Anderson was a tough company with reputation as a strict auditor for Corporate America. This was well reflected in their softer culture of strict dress code and employee policy of wooden gates. With changing times and management organization tried finding ways to become flexible.

The softer aspects like dress codes and wooden gates were relaxed. The dress code became less formal and with this advent gains the employees started becoming more and more flexible. The flexibility relaxed the environment and ultimately had a direct impact on the harder core of the organization. Once the harder core was hit Arthur Anderson crumbled. This was visible in the biggest corporate scandal of America- Enron. Enron was the worst corporate scandal which shook American Corporation. Auditors at Arthur Anderson signed the financial statements of Enron without cross checking the stated facts.

This was done just to rope in extra money from this big ticket client. Somewhere this is an also a case where organizational structure should be questioned. The reason for this is because for a big ticket client like Enron, Arthur Anderson compromised its corporate hierarchy. They allowed their premier groups to go and reside at the client’s headquarter. There was no proper check on what was happening within employees and the client. Cultures are built over a long period of time and once relaxed they can be destroyed in a very small time.

This is visible in classic case of Arthur Anderson. There should be a well developed cultural ethos within the organisation. The most important point is that this ethos should be in sync with each other. If the inner and outer core of the company doesn’t function together, the organisation would crumble like pack of cards. This is what happened with Arthur Anderson. Three Essential Accounting Areas Capital Budgeting J. Dean was the author who has explored this classification in his book “Capital budgeting”, we can distinguish between:

Alternative investment includes replacing old equipment by wear or obsolescence with new equipment. They are by far the most frequent, if not the largest. Their urgency or need leads too often companies to overlook their dangerousity in the opportunity analysis. If this type of investment has in theory no impact on productivity or capacity, it is virtually certain that the these concerns are integrated; The modernization investment or productivity investment that should reduce operating costs and improve productivity and product quality.

Sometimes it’s investment in innovation. Investments upgrade also aim to improve the overall competitiveness of the company for the upgrade requirements of local competition and / or international; The expansion investments relate to the increased potential for production and distribution in the same business or in a different activity, such as launching new products or increase the production and sales of existing goods or services .

The majority of analytical techniques have been developed to study such investments; The restructuring investment aimed at general business technical difficulties, financial or trading and is carried out in order to boost activity, retrain and redeploy some of the new areas; Strategic investments are investments which are important to ensure the sustainability of the company, it is often impossible to evaluate even very approximately the expected outcomes.

We can take the example of research conducted by the pharmaceutical or chemical companies … There are at this level two types of offensive and defensive investments: * Defensive type in order to lower competitive pressures through vertical integration, cost reduction and internalization of margins, for example; * Offensive type, to increase the market power of the company and expand its economic and financial outlooks. * The investment imposed by circumstances or by the Government.

This is the first social investment purposes that have no direct connection with the activities of the business (restaurants, accommodation for staff etc… ). We can also think about other investments that the company does would not do if they weren’t obvious: parking control equipment, security check in the company, etc. In reality, it is often impossible to determine precisely which category above characterizes a particular investment.

For example, an investment expansion may be at the same time a modernization investment and a strategic investment. Similarly, because of technological changes, alternative investment can be at the same time an imposed by circumstances or by the Government one, but should also contribute to the modernization of the company. However, this classification is interesting from a conceptual point of view. It shows that an investment does not represent a single category of investment expansion.

Modigliani and Miller (1958: 261-297) criticise the prediction made by traditional theory that level of debt in capital structure influences the additional use of debt in capital structure when firm need additional capital to fund its operations. They argue that value of firm is independent from the capital structure decisions. According to MM proposition I, the value of firm is the determined by the value of assets and cash flow generated by them instead of value of equity and debts.

Supporting this argument Modigliani and Miller state that the capital raised to finance firm’s assets is not worth more than market value of its assets. Therefore, no mix of debt and equity is better than other. MM’s theory holds under certain number of assumption as no corporate and personal tax exist, there is perfect capital market exist in which firms and individuals can borrow unlimited or countless amounts on same interest rate, and personal borrowing is assumed perfect substitutes for corporate borrowing.

Modigliani ; Miller (1963, pg 433-443), corrected their earlier view that cost of capital and firm’s value are not affected by debt level in capital structure. MM proposition II state that, the capital structure decisions are influence by the fact that cost of capital and firm’s value is affected by the financing decisions related to leverage ratio. Moreover, proposition II clarify that expected return on stock increased from a leverage level. The “no corporate tax” assumption was relaxed in proposition II, so firms are subject to get tax benefit from use of debt.

Theory further comments that the rise in cost of equity is proportionate to the gearing ratio, which offsets the increase in the cost of equity resulting in constant average cost of capital (WACC). Modigliani and Miller (1963) suggest that the arbitration process will lead to the identical equilibrium value of two such firms which are exposed to similar business risk but don’t have same value. Investments 1 – The investment amount is the total funds actually disbursed and spent, now or not, by the company for the investment. * It incorporates at the time of the investment: The cost of acquisition or construction and related costs of transportation and installation; * The value of property used in the project. It can be an already owned property (premises, land, others equipment). This value can be a market value or based on historical cost; * Patent acquisitions, costs of hiring and training of staff related to the project before starting the operation. On the basis of investment codes, capital goods are exempt from added value tax and should therefore be included at the value without tax.

In case of replacement investment, the investment amount should be reduced by the residual value of old equipment and more generally of any assets that become unnecessary due to the completion of the new investment. This corresponds to the divestment made in establishing the new investment. The amount of the investment must be reduced by the value of property disposal engendered by the divestment. The value must also be corrected from the tax effects of any capital gains realized on the sale: If sale value ;gt; acquisition value: there is a capital gain which causes an additional tax rate.

Investment expenditure = Amount of investment – Transfer + tax capital gain. If sale value ;lt; acquisition value, there is a less capital gain that results in tax savings. Investment = Investment expenditure – income tax on depreciation. Note: Capital gains on disposal of assets are exempt from business tax if the sale amount is reinvested within three years thereafter. Note that the residual value achievable at the output of new investment will be added to the cash flows of the last year of the life of the project.

The net amount of investment must also take into account the change in working capital related to the achievement of investment: new increase in working capital – reduction in working capital assets related to divestment. If there is need to increase inventory and customer credit because of the expected increase of activity, it must integrate this additional capital funds circulating in the capital investment expenditure, updated appropriately. The increase in working capital need must be expressed in percentage of turnover (% turnover without tax). Capital Structure

A capital structure is defined as a mix of permanent long term capital employed by enterprises to run their operations and to meet their long term project investment needs. There are two main sources available from which a firm can obtain finance. They are internal (retained earnings) and external (debts and equity). The retained earnings is also part of equity or share capital and, it is seen an investment in firm from the existing shareholders for which they will get more return in future. Eventually there are two main source of finance as equity and debt.

Hence, the capital structure decisions are associated to adjustment of this mix of two variables namely debt and equity, in order to minimize average cost of capital and maximize the market value of firm. It is often seen that the mix of debt and equity varies across firms and industries depending on various factors such as type of industry, firm size, kind of assets employed by firm so on. Modigliani ; Miller (1963, pg 433-443), corrected their earlier view that cost of capital and firm’s value are not affected by debt level in capital structure.

MM proposition II state that, the capital structure decisions are influence by the fact that cost of capital and firm’s value is affected by the financing decisions related to leverage ratio. Moreover, proposition II clarify that expected return on stock increased from a leverage level. The “no corporate tax” assumption was relaxed in proposition II, so firms are subject to get tax benefit from use of debt. Theory further comments that the rise in cost of equity is proportionate to the gearing ratio, which offsets the increase in the cost of equity resulting in constant average cost of capital (WACC).

Modigliani and Miller (1963) suggest that the arbitration process will lead to the identical equilibrium value of two such firms which are exposed to similar business risk but don’t have same value. Tradition theory of capital structure states that the average total cost of capital can be reduced by adding more debt in capital structure. This theory predicts an optimum level of debt and equity mix which results in decrease in the average cost of capital to minimum level and increase in firm’s value to a maximum point.

Further, this theory interprets that the firm’s value will start reducing if firm continue to increase the debt capital beyond the optimum level as a result of increased risk imposed by use of additional debt. This theory’s predictions are based on following assumptions: * Capital structure is made of only debt and equity, and any upward or downward change in leverage occurs through the simultaneous issue and maturity of securities. This means issuing equity should match with maturity of the debt. * There is no corporate and personal tax exists and all earnings are given out to the investors which results in no growth of the firms. There are no costs which arise as a default of the issued bonds and bankruptcy costs and business risks remains static over time. The traditional theory of capital structure dictates that there are three main different stages whereby the combination of debt and equity reflects diverse WACC and diverse market values of firm at each stage. Trade off theory The trade-off theory explain the trade-off between the rise in value of the firm as a result of debt tax shield and rise in cost of financial distress as a result of increasing leverage in capital structure.

This theory points out that there is an optimum level of gearing that would be a target debt level for a firm as, at this target point of debt the value of the firm is maximum and average cost of capital is minimum simultaneously. Therefore, the target debt level, which is determined by trade off between financial distress and tax saving benefits, is the determinant of firm’s capital structure decisions. If MM’s II proposition holds true then, firm’s value continuously increases as long as firm possibly keep borrowing assuming that there is no cost of transactions and cost of financial distress.

Furthermore, the traditional theory and MM’s theory both are not clear on how the financial distress and bankruptcy costs determine the capital structure decisions. Financial distress is an important factor which influences the capital structure as suggested by trade off theory. Trade off theory states that if a firm keep borrowing infinite then financial distress arises as a result of risk of default of debt obligations, and investors expect more high return resulting in increased cost of capital.

Therefore, trade off theory attempts to show how the trade off between cost of distress and tax shield benefits determines an optimum capital structure. Under trade off theory optimum capital structure is viewed as target debt level and this target level is a driving force of firms’ capital structure decisions. Hence, the trade off theory shows that the firms’ capital structure decisions are affected by target optimum debt level since firms adjust their debt and equity ratio to achieve the optimum capital structure, as shown in figure 2. below. Sunder, L. S. and Myers S. C. , (1999: 219-244) comment that optimum requires a trade-off between advantages of tax shield and cost of financial distress whichoccurs when the firm realises that it has too much debt in its capital structure. Contrast to the MM’s proposition, trade off theory suggests that if firms keep borrowing then they will face financial distress at some stage of leveraging that can lead the firms to bankruptcy process if firm keep borrowing.

Hence, the possibility of financial distress is predicted, by theory, to have an influence on firm’s capital structure decisions that suggest that firm should not borrow additional amount of debt when there is a possibility of financial distress that occurs when firms reach close to bankruptcy procedure. Conclusion The paper looked at various aspects of the accounting world and how it is structured. It looked at evolution of how disclosures became so important. The paper focused on critical theories and showed how regulators became so important to the stakeholders. They became the police to the corporate world.

Regulatory capture theory helps in managing the accounts on the basis of the regulators of accounts of the company. This is actually the way the corporate structure and the regulators work together. This framework helps in establishing the real accounting world and its controls.