Accounting Theory and Practice: Answers to Questions on Accounting Methods and Hypotheses

This article provides answers to questions on accounting methods and hypotheses, including the use of conservative accounting methods, political cost hypothesis, and debt/equity hypothesis.

Running head: ACCOUNTING THEORY AND PRACTICE
Accounting Theory and Practice
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Table of Contents
Answer to Question 1:.....................................................................................................................2
Answer to Question 2:.....................................................................................................................2
Answer to Question 3:.....................................................................................................................2
Answer to Question 4:.....................................................................................................................3
Part (a):........................................................................................................................................3
Part (b):........................................................................................................................................3
References:......................................................................................................................................5

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Answer to Question 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.
Answer to Question 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.
Answer to Question 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,

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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.
Answer to Question 4:
Part (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.
Part (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

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 Reduction in sale of non-current asset
Hence, it is not possible to describe upward revaluation with the help of management
compensation hypothesis.

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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.