Financial Accounting Theory: Determinants of Accounting Policy Choice

This report examines the determinants of accounting policy choices under international accounting standards (IAS), focusing on the freedom given by the IASB for entities to select accounting policies. The study aims to identify key factors influencing these choices, using a positive accounting theory approach. The report identifies seven determinants, including firm size, asset structure, investment opportunities, financial leverage, profitability, public ownership, and taxation. The research highlights how these factors, along with the interplay between actors and their self-interests, impact accounting policy decisions. The conclusion emphasizes the need for standard setters to reduce the scope of alternative methods in IASB standards to improve the quality of financial reporting. The report also references several studies that support the analysis of accounting policy choice determinants.

Running Head: FINANCIAL ACCOUNTING THEORY
FINANCIAL ACCOUNTING THEORY
Name of the Student
Name of the University
Author Note

1FINANCIAL ACCOUNTING THEORY
Executive Summary
IASB gives freedom for making choice of certain policies of accounting for reporting entity
with intention to allow managers for making choice of accounting policy with the help of
which true and fairness of economic information provided by the organization can be
enhanced. This paper aims at examining determinants of the accounting policy choice under
the international accounting standards. Hence, seven determinants of the choice of accounting
policy have been found. This paper suggests that the standards setters as well as regulators
needs to reduce the scope of alternate methods allowed in the standards of IASB, which will
ultimately help in improving reporting quality of firms.

2FINANCIAL ACCOUNTING THEORY
Table of Contents
Introduction................................................................................................................................3
Research Question......................................................................................................................4
Literature Review.......................................................................................................................4
Theoretical Framework..........................................................................................................4
Determinants of Accounting Policy Choice...........................................................................4
Conclusion................................................................................................................................11
Reference..................................................................................................................................12

3FINANCIAL ACCOUNTING THEORY
Introduction
IFRS permitted freedom of choice, where alternative accounting policy applies has
resulted into undue flexibility that leads towards adoption as well as application of the policy
of accounting for serving one’s self interest, such as earning management and tax liability.
The concern of this study is based on the wide ranges of policies of the accounting under
IFRS. These accounting policies that are available to company is having different accounting
treatments in case of same transactions. These alternatives are having equal chances for being
applied and adopted to the events, transactions and events, without altering any IFRS section.
The alternative policy permitted by IFRS presents great choice of freedom and the undue
flexibility. When management are faced with such choice for selecting the alternative policies
has resulted into accounting policies’ application and adoption for serving their own self-
interest. The accounting policy is consisting of techniques, systems and procedures of
measurement.
The applied accounting policy needs to be determined by the reference to specific
standard, where IFRS provision specifically applies to any event or transaction. Further, IFRS
states that in case of no specific standard, management of company needs to use their good
judgement for developing policy or the set of policies for applying. These policies are
required to results in the financial information, which is relevant to economic-decision
making requirements of users. For making judgement, management are required to consider
IFRS requirements on the similar and the related issues. Moreover, there are various research
conducted in these areas, but these researches have not able to conclusive results. The gap
remains exist. Hence, this research paper aims to close the existing gap by examine
determinants of the accounting policy choices under the international accounting standards
from positive accounting theory approach.

4FINANCIAL ACCOUNTING THEORY
Research Question
This paper aims to conduct the research study for answering following question:
 What are determinants of the accounting policy choices under the international
accounting standards?
Literature Review
Theoretical Framework
Positive Accounting Theory
Positive theory is the theory, which seeks for explaining and predicting the particular
phenomenon. According to Watts, the use of positive research term was popularized in the
economics by the Friedman and it was used for distinguishing research, which sought to
predict and explain from the research, which aimed to provide the prescription. The “positive
accounting theory” by Watts and Zimmerman provided refreshing and significant
contribution to the thought of accounting. This is important due to its vigorous emphasis on
actual financial accounting technique of entity. This theory tried to make the good predictions
of the real events of world and translate them in the transactions of accounting. This theory
tries to explain behavior of manager in accounting procedures choice. The accounting
numbers are used as significant part of firm’s formal and the informal contracts. The positive
accounting theory of the decision regarding accounting method choice helps in making
number of assumptions relating to the behavior of managers. This theory helps in explaining
economic implications of the existing methods of alternative accounting treatment.
Determinants of Accounting Policy Choice
According to Mahesh Joshi, amidst of the fast-changing world, institutions of the
accounting world are in the process of the integrating universal language. The financial limits
in between the countries are disappearing because of technological advancement,

5FINANCIAL ACCOUNTING THEORY
international trade, international financial market growth, influence of the financial
organization and increased level of FDIs. The reduction of the financial boundaries is
allowing large business for approaching international capital markets for expanding their
operations of business. The accounting professionals supports adoption of IFRS and their
thoughts does not significantly by training place, professional qualifications or experiences.
The finding of this paper shows that media, government and the professional accounting
bodies have supported application, adoption and communication of the IFRS (Joshi, Yapa
and Kraal 2016).
Principle based IFRS helps in allowing flexibility within the standards of accounting
by stipulating the alternative policy of accounting for treating specific issues of accounting.
The adoption accounting policy is consisting of three steps, which are flexibility in the
financial reporting, choice of accounting policy and the final stage is review of policy choice.
The accounting policy choice depends on two perspective of the positive accounting theory,
for instance opportunistic perspective and efficiency perspective. The managers who are
opportunistic deviates from the efficiency perspective because of different persuading factors,
while determining choice of accounting.
According to Muhammad Jahangir Ali, the existence of some flexibility in the
accounting standards of IASB allows the managers for using methods of increasing or
decreasing the income. There exists scope for the standard setters and regulators for reducing
alternative methods that are likely to enhance reporting quality of firms (Ali and Ahmed
2017). The researchers outlined following determinants of the accounting policy choice under
the international accounting standard:
Firm’s Size

6FINANCIAL ACCOUNTING THEORY
It has been argued that the big firms are more subject to the negative influences, for
instance high rate of tax, legal regulations, government and public scrutiny and others. This
results in adopting profit reducing policies of accounting for avoiding political cost. Further,
it has been highlighted by Watts & Zimmerman through positive accounting theory that the
big firms employ the policies of accounting that reduces income.
Assets in Place
The capital-intensive firms generally report more profits in comparison to labor
intensive firms and they are expected to use the income reducing policies of accounting for
distorting actual profit with the view to avoid political cost. There is higher possibility of
these capital-intensive firms for generating high earnings compared to high-growth
alternative firms.
Investment Opportunity Set
The opportunity of investment sets as the significant factor. The firms having higher
opportunities of investment are found to adopt income increasing policies of accounting.
Financial Leverage
Financial leverage is the significant determinant factor identified in various
researches. The leveraged firms are generally found to adopt income increasing policies of
accounting for meeting banks requirement, irrespective of corresponding increase in the
payments of tax.
Profitability
The incentives of management are linked with the profitability measure as stated by
Watts and Zimmerman in respect of positive accounting theory. This theory states that
profitability is identified as proxy for the schemes of incentive. When manager’s incentive

7FINANCIAL ACCOUNTING THEORY
schemes are linked with the profitability of firm then managers tend to adopt the income
increasing policies of accounting because of personal interest influence. According to PAT,
incentives of managers is the key determinant factor of the choice of accounting, unless there
is interference of other interested groups, for instance shareholders.
Ownership by the general public
Ownership structure of firm is identified as significant determinant by most of the
previous researches. The accountability towards the owners that arises through separation of
the ownership and the consequential management incentive schemes based on performance
motivates the managers for adopting the policies of accounting for matching with in general
personal interest.
Taxes
Lastly, taxation also possess significant influence over the accounting policies
selection as system of financial reporting and tax is having positive relationship with the
system of financial reporting. Positive accounting theory applies in this case because firms
always try to select the accounting policy that reduces tax in environment of business, where
policies of accounting and guidelines of tax are almost indifferent with each other.
According to Catalin Nicolae Albu, translation as well as application of the global
standards of accounting in the local context have great consequences on the relationships
between actors on variation of the practices. The local actors play more significant role in
triggering the responses of organization. It is because responses of organization to these
global standards depends upon the interplay between the actors, who generally search for the
legitimacy and the attainment of their self mutually conflicting interests. The researcher
found that in terms of the practices of accounting, countries are not homogeneous. The intra-
organizational actions and interest are vital for the implementation of IFRS. Here positive

8FINANCIAL ACCOUNTING THEORY
accounting theory applies because decisions regarding IFRS adoption and its policies highly
depends on the relationship between the actors and attainment of their self-conflicting
interests (Albu, Albu and Alexander 2014).
According to Stefano Cascino, change in the standards of accounting for affecting
outcomes of accounting, it is important for having compliance with the standards of
accounting. Firm’s limited compliance or failure for failure of providing the information
required by the standards of accounting limits potential effects of the reforms of accounting
standards. This limited compliance impairs market participant’s ability for comparing
financial reports of different firms. It is associated with the characteristics of firms, which
suggests that lack of the compliance is the response to the incentives, which companies face
in their respective environment of institutions. The researcher found that companies from the
countries that is having tighter enforcement, they experience larger comparability effects of
the IFRs and that the public firms becomes less comparable to the local GAAP private firms
from the same country that adopts IFRS. This approach of company of having lack of
compliance in respect of incentive, exhibits PAT (Cascino and Gassen 2015).
According to Hans B. Christensen, reporting incentives dominates the standards of
accounting for determining the quality of accounting. The quality of accounting is affected by
IFRS adoption for the two firms’ group. The first one is those, who supposedly perceived
IFRS net benefits and the other groups are those, who are not having any incentives for
adopting and they are forced for complying. The voluntary IFRS adoption leads to decrease
in the earnings management, timely loss recognition as well as value relevance. However, the
companies resisting IFRS adoption does not have any improvement in quality. The researcher
found that improvement in the quality highly depends on voluntary adopters. The lack of
incentives for IFRS adoption, subsequently leads to lack of the improvements in quality after
its forced adoption. This finding is in line with PAT because management behavior plays

9FINANCIAL ACCOUNTING THEORY
major role in choice of IFRS and quality improvement of company. For those firms, who
prioritize getting more incentives by not following accounting standards does not voluntary
adopts IFRS and vice versa (Christensen et al. 2015).
According to Lasse Oulasvirta, stated that there are most of the developed countries’
government who are reluctant towards adoption of internationally standardized financial
reporting of public sector because of their political pressure. A globally accepted standards of
accounting serves as growing internationalization of the capital markets and capital
provider’s informational needs. The application of standards is also important for the public
sector accounting. This will create financial statements of public sector comparable across the
countries (Oulasvirta 2014).
According to Robert Libby, there are three mechanism by which attributes of
presentation affects the behavior of user, which includes attributes of presentation can
directly affects the content of information, attributes of presentation can indirectly affect the
information content by their effects on the real or the reporting actions of managers. The
example of presentation attributes, which directly affects the content of information is related
to the reporting of expenses on income statement. There are great differences between
expense reporting through GAAP and IFRS. The current standards of US GAAP provide
little guidance on operating expenses presentation. Further, there are also dramatic
differences of information content that results from the presentation of earnings related to the
differences in the disaggregation of expense provided by the various entities under IAS 1 and
under typical US GAAP. The benefit of this is taken by the managers on earning information
presentation and motives of managers likely underlie their presentation choices. This relates
to the positive accounting theory, which states that accounting standards choice depends on
the choice of manager (Libby and Emett 2014).

10FINANCIAL ACCOUNTING THEORY
According to Michael Minnis, private firm’s location is the great determinant that
substantially affects the environment of financial reporting. The countries such as Canada and
US face no regulation of financial reporting, which means making financial reports public
and auditing it is not important. As the outcome, extent to which these companies engage in
the financial auditing or reporting is effectively result of company’s weighting its private
benefits and cost. However, this is not the case of countries, where financial reporting is
important and essential, regardless of company’s own consideration of private benefits and
costs. The finding of this paper is in line with positive accounting theory because in absence
of regulations of financial reporting, managers and stakeholders can get the chance to
negotiate the requirements of disclosure and act in their own self-interest (Minnis and Shroff
2017)
According to Duc Phan, IFRS adoption is the radical departure from the several
perspectives and it would be influenced and the influential decision. It has been stated by the
researcher that when it comes to make choice between the principles-based accounting
standard IFRS and the rules-based accounting standard US GAAP, the auditors and the CFOs
prefers to choose GAAP. The history of accounting framework used in country has a great
influence in changing the existing accounting standard to the international standard (Phan,
Joshi and Tran-Nam 2018)
The research by Helen Hong Yang provides the insights regarding practices of
accounting on the convergence of China with the IFRS. The companies that are facing the
growing domestic and global institutional pressures for producing the quality financial
reports that is deemed to be beneficial for the investors. The findings of researcher conclude
that Chinese accounting standards have been converged with IFRS with some of the
exceptions. Historical cost accounting is preferred based of measurement to the fair value
accounting. The country faced great challenge in exercising professional judgement. Hence,

11FINANCIAL ACCOUNTING THEORY
this means that the transition and convergence of accounting standards are greatly affected by
the factors such as ownership structure, accounting practitioner’s expertise, management and
their professional judgements. The positive accounting theory states that in the situation
where professional judgement are required, the managers can make take advantage of that,
which may contribute to earning management or other kind of loopholes in the accounting
standard. Moreover, there are great issues in implementation of the international accounting
standards such as IFRS in countries, where there were rule-based accounting standards (Yang
et al. 2018).
Conclusion
Therefore, the conclusion can be reached from this research paper that choice of the
accounting policy is affected by the seven factors, which includes size of firm, capital
intensity, financial leverage, taxation, profitability, ownership structure and investment
opportunity set. The finding of this paper greatly supports the positive accounting theory.
Further, it has been analyzed that the wide ranges of the option of accounting policy
permitted by the IFRS provides room for the freedom of organization that leads towards
operations and self-interest within the limited knowledge. There exists some flexibility in
accounting standards of IASB and managers as well as preparers are having discretion for
selecting particular method of accounting that maximizes their benefits at shareholder’s
expense that leads to greater management of earnings and lower quality of reporting. Hence,
it can be said that irrespective of motive behind choice of accounting policy, the management
of company needs to be mindful of true and the fair view of accounting policy. The
appropriate board of IASB need to look into some of the financial statement items that is
considered as the critical policies but are subjective. This will be of great help in limiting the
freedom choice as well as the undue flexibility.

12FINANCIAL ACCOUNTING THEORY
Reference
Albu, C.N., Albu, N. and Alexander, D., 2014. When global accounting standards meet the
local context—Insights from an emerging economy. Critical Perspectives on
Accounting, 25(6), pp.489-510.
Ali, M.J. and Ahmed, K., 2017. Determinants of accounting policy choices under
international accounting standards. Accounting Research Journal.
Cascino, S. and Gassen, J., 2015. What drives the comparability effect of mandatory IFRS
adoption?. Review of Accounting Studies, 20(1), pp.242-282.
Christensen, H.B., Lee, E., Walker, M. and Zeng, C., 2015. Incentives or standards: What
determines accounting quality changes around IFRS adoption?. European Accounting
Review, 24(1), pp.31-61.
Joshi, M., Yapa, P.W.S. and Kraal, D., 2016. IFRS adoption in ASEAN countries:
perceptions of professional accountants from Singapore, Malaysia and Indonesia. Malaysia
and Indonesia (January 4, 2016), pp.211-240.
Libby, R. and Emett, S.A., 2014. Earnings presentation effects on manager reporting choices
and investor decisions. Accounting and Business Research, 44(4), pp.410-438.
Minnis, M. and Shroff, N., 2017. Why regulate private firm disclosure and
auditing?. Accounting and Business Research, 47(5), pp.473-502.
Oulasvirta, L., 2014. The reluctance of a developed country to choose International Public
Sector Accounting Standards of the IFAC. A critical case study. Critical Perspectives on
Accounting, 25(3), pp.272-285.
Phan, D., Joshi, M. and Tran-Nam, B., 2018. The history of accounting standard setting in an
emerging transition economy: The case of Vietnam. Accounting History, 23(3), pp.379-406.

13FINANCIAL ACCOUNTING THEORY
Yang, H.H., Clark, C., Wu, C. and Farley, A., 2018. Insights from accounting practitioners on
China's convergence with IFRS. Australian Accounting Review, 28(1), pp.14-27.