Accounting Methods' Impact On Organizations - An Essay.

1. If senior managers within a company were rewarded by way of accounting-based bonus plans then would they, or the owners/shareholders (or both), prefer the use of conservative accounting methods? Explain the reasoning for your answer.

2. Zhang (2008) argues that if a borrower adopts conservative accounting methods this will reduce the risk exposure of the lender and will lead to a reduced interest cost for the borrower. What is the basis of this argument?

3. If a reporting entity has a choice of either expensing or capitalising an item of expenditure, and if the entity is subject to a high degree of political scrutiny, then what choice would be predicted by the political cost hypothesis of Positive Accounting Theory? Explain your answer.

4. Assume that Kahuna Company Ltd decides to undertake an upward revaluation of its non-current assets just prior to the end of the financial year, the effect being that the total assets of the company increases, as does the total shareholders’ equity.
(a) Explain the decision of management to undertake an asset revaluation in terms of the debt hypothesis of Positive Accounting Theory.
(b) Explain the decision of management to undertake an asset revaluation in terms of the management compensation hypothesis of Positive Accounting Theory.

Accounting-based Bonus Plans and Conservative Accounting Methods

1. In case, accounting-based bonus plans are used for rewarding the senior managers within an organisation, they would not prefer conservative accounting methods. The methods need a degree of verification before any legal claim is made for profit. The recognition of expenses or losses would be made at the time they are incurred (Brigham et al., 2016). Hence, it would not be possible to manipulate any information for reporting a better financial position than the actual one. Both shareholders’ equity and managerial compensation would be based on the actual financial position of the organisation, which is beneficial for the managers, if the organisation has recognised losses.

2. According to Zhang, when any borrower adopts conservative methods of accounting, it would minimise the risk exposure of the lender and the borrower would have minimised interest cost, which is a correct opinion. This is because from the efficiency perspective, managers might prefer to follow conservative accounting methods, as it enables them in attracting at a lower price (Clegg, Kornberger & Pitsis, 2015). The utilisation of conservative accounting methods implies the debt covenants limiting debt amount in relation to assets. Moreover, the increasing binding covenants would provide prior signal of default risk, which would minimise the risk exposure of the lending party like the bank.  

3. In the words of Jones (2015), the political cost hypothesis estimates that the big organisations rather than small organisations are more prone in utilising accounting choices, which minimise reported profits. For political attention, size is taken into account as a proxy variable, which implies that the bigger the organisation, the more probable it is assumed to be subject to political inquiry. In case, it is assumed that an organisation is subject to increased extent of political inquiry and greater profits would draw unwanted political attention, the organisation would expense an expenditure item, instead of capitalising the same.

4. a) According to debt/equity hypothesis, the greater the ratio, the more probable that the managers would use accounting methods that raise income and decrease the probability that an organisation would violate any debt covenants that might exist. In case, Kahuna Company Limited undertook upward revaluation just before the year end, the debt hypothesis would recommend that perhaps the organisation is near to violate a debt covenant and it is necessary to conduct revaluation for minimising the probability of a technical default associated with the debt agreement.

b) According to management compensation hypothesis, it is projected that the managers of the organisations having bonus plans are more probable to utilise accounting methods, which raise the reported income of the existing period. If an upward revaluation is undertaken and assets are depreciable, the depreciable asset base would rise resulting in rise in depreciation expense and fall in profits (Khan, 2015). Moreover, there would be following outcomes in case o upward revaluation:

• Crediting revaluation surplus
• Reduction in sale of non-current asset

Hence, it is not possible to describe upward revaluation with the help of management compensation hypothesis.

References:

Brigham, E. F., Ehrhardt, M. C., Nason, R. R., & Gessaroli, J. (2016). Financial Managment: Theory And Practice, Canadian Edition. Nelson Education.

Clegg, S. R., Kornberger, M., & Pitsis, T. (2015). Managing and organizations: An introduction to theory and practice. Sage.

Jones, S. (2015). Development of financial accounting theory. In The Routledge Companion to Financial Accounting Theory(pp. 21-31). Routledge.

Khan, M. (2015). Accounting: Financial. In Encyclopedia of Public Administration and Public Policy, Third Edition-5 Volume Set (pp. 1-6). Routledge.