Advanced Financial Accounting: Risk, Earnings, and Regulation

This report delves into advanced financial accounting, focusing on the application of Positive Accounting Theory (PAT) to analyze the risk-taking behavior of managers. It examines how managerial pay linked to firm performance influences these behaviors, particularly in the context of earnings management. The report defines earnings management as the legal and reasonable management of financial results to achieve predictable outcomes and explores the relationship between ethics and earnings management, suggesting that strong ethical standards discourage manipulation. Additionally, it discusses the Public Interest Theory, which advocates for increased regulation to protect the public from market failures. The report covers the conceptual framework of financial accounting, PAT's hypotheses, and the factors that influence managers to engage in earnings management activities, including stock market incentives and ethical considerations. It also analyzes the impact of earnings management on financial reporting risks and the role of public interest in regulating executive pay.

Advanced Financial Accounting

Abstract
The main objective of financial reporting forms the foundation of framework. Using this
framework of Positive Accounting Theory this paper analyses the risk taking behaviour of
managers. The main focus of PAT is on the relationship between the individuals which provide
various resources to the organization. This truly explains the risk taking behaviours of the
manager’s when the managerial pay gets linked with the firm’s performance. Realising the
importance of earnings, earning management can be defined as reasonable as well as legal
management decision making as well as reporting which tries to gain predictable along with a
stable financial results. There is found to be strong relationship between ethics and earnings
management thus a stronger sense of ethics in managers is one such factor that will discourage
earnings management . According to public interest theory regulations is a method or channel
that helps the public to protect itself from market failures .

Table of Contents
Abstract............................................................................................................................................2
1. Introduction..................................................................................................................................4
2. Part 1............................................................................................................................................4
3. Part 2: Concept of Earnings Management...................................................................................6
4. Part 3: Public Interest Theory......................................................................................................8
Bibliography..................................................................................................................................12

1. Introduction
There is no as such a definitive view regarding the components of a ‘conceptual framework’.
The Financial Accounting Standards Board (FASB) , in the US developed the first ever
conceptual framework in the field of accounting and this conceptual framework has been
defined as a coherent system that consists of interrelated objectives as well as fundamentals
which leads to consistent standards. As per the definition of FASB for conceptual framework it
is quite structured and they possess several normative characteristics. (Deegan, 2009) .
Considering this conceptual framework of financial accounting this report uses Positive
Accounting Theory in order to analyse and explain the risk taking behaviour of managers.
Furthermore it explains the concept of earnings management along with the several factors
which impact the managers to perform earnings management activities. Finally the Public
Interest Theory is being explained which argues the proposed increase in regulation of executive
pay done by the Australian government is in the public interest.
2. Part 1
The Positive Accounting Theory is an accounting theory which is related to explanations about
accounting practice it has been designed to predict as well as explain which company will and
which ones will not use specific method, but it does not tell anything about which methods
should be used by the firm. This can be the relationship between the mangers and the owners or
between the firm’s debt providers and the managers. Out of the three major hypotheses that are
used very frequently in PAT bonus plan hypothesis is very crucial (Watts & Zimmerman, 1990).
According to the bonus plan hypothesis the managers of the firms having bonus plans will be
making use of accounting methods so that the current period’s reported income will be
increased this is also referred to as management compensation hypothesis and according to it
action results in increasing the current value of the bonuses that are paid to the management.
Linking the managerial payments with the performance of the firms motivates them to
perform better for shareholders on one hand , but on the other hand it also burdens the managers

with greater risks which they might not want to carry. AS can be seen the earnings management
is being supported by the positive accounting theory framework which was initiated by Watts
and Zimmerman (1978). Choosing the accounting policy indicates the informational advantage
as well as contractual relations of managers. The major assumption that comes up based on the
nature of contracts is the assumption of compensation. The inclination of executives is seen
towards the profits that can be earned from accounting deficiencies in order to impact the
contents of the financial statements of the firm for their personal interests. Considering the
opportunistic viewpoint, the managers mostly make use of their personal discretion in order to
enhance their compensation that can be determined by both the market value (stock options) as
well as accounting performance (bonus). This kind of opportunistic behaviour shown by
managers can result in earnings for management practices.
The CEO’s in current highly complex business world bear the weight of performance systems
as well as the solemnity when their duties are being incepted so that they sell their business at
good value. Mangers in some cases might choose and exploit the privilege position that they
occupy in order to obtain private gains through management of financial reporting in their
favour. There have been several studies that have analysed the issues like management
motivation in order to develop an accounting behaviour. Tax is considered to be a significant
motivator that assists in development of earning management as well as creative accounting
(Niskanen & Keloharju, 2000) . In such cases positive accounting helps in making wiser
predictions about the events happening in real world as well as translates them into accounting
transactions.
Scandals as well as corruptions are not juts limited by staying within the corporate houses, but
they have spread their wings to the custodians of corporate businesses. Thus all the stakeholders
who also include the investors are at risk as they are not for sure about the fact that they would
be able to their base investment not just because of market volatility, but form the financial
reporting risks as well (The Economist, 2014). Alongside the stand alone risk exposure due to
earnings management done by the managers in the firm or by the accountants is also very
material. According to the efficiency perspective of positive accounting theory which is also
called as an opportunistic perspective, the managers who act as agents of the owners that are the
shareholders etc. act only for their self-interests. They just adopt the accounting policies which

are beneficial for them and they think that whatever is advantageous for them will be good for
the firm too. According to the bonus scheme or compensation hypothesis the managers who
have accounting incentives or whose remuneration is being connected with the accounting
performance of the firm will manoeuvre accounting methods in such a manner that the
accounting figures get reflected in a better manner . In this case the uncollectible allowance,
research and development costs as well as method of depreciation will be handled in such a
manner that it incentivizes the manager (Shil, 2015).
Furthermore according to the debt-equity hypothesis the managers will start making up or
cooking the financial statements that will reflect better profits which are similar to the bonus
plan with the expectation of showing better liquidity position as well as performance that also
indicates the better position to pay the principal along with the interest of the debt owners
(Lakhal et al., 2014). The article also states that the CEOs and their acolytes know how to play
with the financial system thus creating easy targets for themselves so that they can be paid
millions through blue chip range of short term as well as long term bonuses that are not
available for the average worker or shareholder. They thus start delivering good performance
for the shareholders but at the same time puts burden on them with greater risks than they can
bear (Pash, 2014).
3. Part 2: Concept of Earnings Management
Earnings also known as “net income” is very crucial item in any financial statement as it
indicates the amount to which firms engage in value added activities. Earnings management is
something which should not be confused with various illegal activities that are used for
manipulating financial statements as well as report results which do not show the economic
reality (Lev, 1989). Such kind of activities are commonly referred to as “cooking the books” and
in them the financial results are misinterpreted. Various studies conducted on earnings
management indicate that it is totally a pervasive phenomenon. This means that around 8 to 12
percent firms having small pre-managed earnings decreases control their earnings in order to
show increases in earnings and 30 to 44 percent of the companies having small pre-managed
losses manage their losses in such a manner that they can create positive earnings. Thus it can

also be said that there are large number of firms which implement earnings management in
order to have steady earnings growth or simply to escape reporting a red ink (Burgstahler &
Dichev, 1997).
All these definitions of earnings management describe the proper as well as reasonable
practices which form a part of a well-managed business that helps in giving right value to their
shareholders Earnings management is mainly achieved with the help of proper management
actions which helps in easily achieving the required earnings level with the help of :
 Accounting choices from among GAAP
 Operating decisions (economic earnings management)
Managing earnings is considered to be the process in which deliberate steps are taken within
the constraints accounting principles that are commonly acceptable in order to achieve the
desired level of the earnings reported (Rahman et al., 2013). A purposeful intercession in the
process of external financial reporting in order to gain some or the other personal gain .
However real earnings management is a bit extension of the above definition which can be
attained through timely financing decisions as well as timely investments to alter the earnings
reported . Thus basically earnings management deals with the context of financial reporting that
includes the structuring of transactions so that required accounting treatment applies. Earning
management also occurs through well times real investments as well as financing decisions
(Beneish, 2001).
There are several factors which impact the managers to perform earnings management activities
for example stock market incentives, political and regulatory motives and personal incentives.
As per the ethics perspective there have been various features identified of the accounting
treatment by researchers which impact the assessment of ethical acceptability of any specific
practice of accounting (Kaplan, 2000) . There are several factors which impact the actions of
managers in relation to earnings management as there is presence of a strong relationship
between ethics and earnings management . Earning management is connected with providing
misleading financial information to its investors , whereas the intention of managers regarding
managing the earnings is connected with their ethics. Thus if a manager has a strong sense of
ethics they will not be managing earnings , their values and beliefs will not permit them to

manage earnings. Managers might perceive the earnings management in ethical perspective as
more harsh as compared to shareholders and that is why the studies indicate that incentives
should be given to managers for managing earnings (Parfet, 2000).
Next the economic factors have been analysed that impact earnings management activities in
relation to capital markets and management compensation. Management compensation is
considered to be very strong incentive in case of earnings management done by managers. It
helps in aligning management behaviour with the shareholder’s interests as the interest of both
these groups are found to be in conflicting state. There are many examples in accounting
research that show that earnings management for several reasons and amongst them capital
market incentives are considered to be the most stronger one in case of managers in order to
manage the earnings . The reason being the rise in stock market valuations along with the
increase in stock-based wealth as well as compensation impacts the earnings management.
Considering the importance of reported accounting income , there is one assumption that over a
period of time managers try to smoothen the income so that much stable earnings come up
along with an year-to-year variance and this will result in higher firm valuation. Some studies
also indicates that managers try to manage the earnings in order to avoid the earnings declines
as well as reporting losses (Barth et al., 1999). Along with this there are several reasons that
result in earnings management and there are strong evidence that show that managers manage
earnings in order to meet the expectations of the capital markets .
4. Part 3: Public Interest Theory
Public Interest Theory is very important economic theory of regulations and states that
regulations are being developed in response to the public demands in order to correct
inefficient / inequitable market practices. As per the theories of regulation, regulation is
considered to be of public good which come up because of government interventions which are
also exposed to varied kinds of political as well as economic forces. The main aim of
regulations is to protect public interests . Therefore under the public interest theory regulations
arise as a response to the market failures crisis which is seen and are capable of resolving
things in public interest. Like in case of financial accounting standard setting process done

through government intervention is considered to be necessary due to failures to furnish
accounting information’s in proper manner in markets. In the same way the US Securities and
Exchange Commission was developed in 1934 after the 1929 stock market crash down and
after the corporate scandals like the collapsing of Enron the Sarbanes –Oxley Bill related to
accounting and corporate governance was being passed ( Ijiri 2005).
According to Public Interest Theory the markets are very fragile and they also have the tendency
to be inefficient in operations as well as in favour of individual by simply ignoring the societal
importance. Thus to monitor as well as direct the intervention form government is very much
needed. In the same way the Australian Government regulates the banks so that they work
towards the social interest. The banks can and serve the social interest if the resources are
allocated in right manner and in social interest. The Public Interest Theory was being
developed by Pigou and it states that regulators try to find out the market solutions which are
efficient in economic terms. It also mentions that the market power possessed by companies in
case of imperfectly competitive markets needs to be controlled . Mainly in case of natural
monopolies regulations are very much compulsory to increase the outputs and at the same time
to decrease the prices. Whereas in case of oligopolistic markets , regulations are implemented
or required to avoid cut throat competition.
Thus to regulate the banking sector a new Banking Executive Accountability Regime (BEAR)
has been developed which is connected with licensing the senior executives in big banks . The
regulations of BEAR states that the senior executives will have to be registered with the
financial regulator APRA and just in case these executives misbehave , they will be losing their
license as well as their bonuses that are due. This way the financial impacts will be increased ,
as the bonuses will be prevented from being paid for the decisions that will affect the banks or
public for longer period of time. Thus the potential result of asking for variable remuneration
to be accepted will be that the banks will be making adjustments to their payment structures
thus making shift of balance of payments to the base remuneration in this case. The banks have
been knocked by various scandals that include charging for the financial planning advise that
have not been even provided to them. Many planners have been dismissed as well as
deregistered but none of the senior executives have yet lost their jobs in the entire fall out.
There has been rise in the community , regarding the unease like poor culture as well as

behaviour in the banks as well as in the financial sector . There have been many incidents where
the participants have been ill-treated by the financial institutions as well as by the banks.
Therefore as per the public interest Theory the government acted in the House of
Representative’s committee enquiry and their findings and came up with regulations to
enhance and strengthen the competition as well as accountability in the banking system.
Some of the major banks have a poor compliance culture and they have repeatedly been
unable to protect the interests of consumers this kind of culture has been created by the senior
executives in the banks and financial institutions. This culture has been unacceptable and major
changes have been announced in public interest related to regulations; penalties and pay. Thus
the banks must now get registered their directors as well as senior executives with APRA along
with that provide the amps about their roles as well as responsibilities. APRA also has the power
to remove them or it can also impose penalties on the banks which do not work strictly on
monitoring the suitable senior executives. Thus all the directors as well as senior executives
will come under the scanner of APRA and will be punished if found wrongdoing. Even the
bonuses given to the senior executives can be deferred for minimum 4 years span. APRA will be
having stronger powers and ask the concerned banks to adjust as well as review the
remunerations policies to the senior executives and director (Pash, 2014) .
5. Conclusion
Thus it is evident that positive accounting which is very different from conservative accounting
as it has contractual view which puts it in tension or risk with the value relevance studies of
accounting. According to the PAT the managers in firms have an opportunity in positive
perspective according to which they adopt accounting policies that are just beneficial for them
and they follow the compensation hypothesis means they manoeuvre the accounting methods so
that the accounting figures get shown in positive manner. Earnings management happens when
the managers make use of their judicial powers in financial management along with structuring
transactions in order to change the financial reports in order to mislead some stakeholders
regarding economic performance of the firm or in order to influence the contractual results

which rely on reporting the accounting numbers. There are both ethical as well as economic
factors that influence the earnings management activities of the managers. Management
compensation is considered to be very crucial inventive that helps in earnings management. AS
per the Public Interest Theory the regulations are for regulating the firms so that the availability
of few goods is being guaranteed which otherwise will not be possible and profitable in order to
induce unregulated firms.

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