Application of Accounting theory Case Study
Virtually every business venture is a risk taking exercise. However, before taking any kind of risk, whether it is small or it is big, an entrepreneur is expected to make some judgment. The principal must weigh and predict the possible consequences and then make the final stand based on the consequences. The best way of achieving this objective is by adopting the positive accounting theory.
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Positive accounting theory describes how accounting systems operate and hence can act as a helpful framework that can be used to guide CEO’s on what to risk and what not to risk (Deegan, 2014). For example, positive accounting theory can explain what course of action a CEO should take when there are uncertainties. Short term-focused remuneration, for instance, is one of the uncertainty that often force CEO to leave a given venture because most CEO’s such as the one described in article tend to have the perception that short term-focused remuneration is an indication of impending downfall.
However, using the positive accounting theory, this report would be able to answer questions such as: should CEO invest in a project characterized by short term-focused remuneration?, when should CEO’s undertake risk aversion?, and also what should be the basis for decision making for CEO’s? The analysis would be based on the assumption that CEO’s or management earnings are motivated by management’s desire to maximize their own compensation. Consequently, the limitation associated with the report is that the assumption generalizes that all managers or CEO’s earnings or compensations are motivated by management’s desire to maximize their own compensation. This assumption may not be true for all managers of CEOs. The report will achieve the objective by answering some questions related to the “fearful CEOs”
Explain what “short-term focused” remuneration is. Provide few examples of these “short-term focused” remuneration use in Australia to reward managers. For this purpose, you may investigate few annual reports in any industry you are interested in.
Before describing what “short-term focused” remuneration is, it is important to note that the behavior of managers and CEO’s in every organization is very crucial towards the performance of an organization. According to the opportunistic perspective of positive accounting theory, particular accounting methods might initially be selected for efficiency reason, but once they have been negotiated/agreed, then CEOs will aim to utilize accounting choices in a way that best serves their own interest.
The opportunistic perspective believes that managers are assumed to opportunistically act to maximize their own wealth. Because of this, it has been found that in the absence of controls to reduce opportunistic behavior, CEOs expected to undertake activities that disadvantageous to the value of the firm. This means that depending on how they are compensated, managers would act in a particular way, which may favor or may not favor the organization or the company in question. Because of this, it is expected that the principal should pay the manager in the right manner. The principal should reward the agent or manager of CEO accordingly.
There are two major methods of rewarding CEOs. The first method is called the fixed basis. This is where the principal or the owner reward the CEO independent of performance. The next form of rewarding, which is very important is salary plus remuneration. This is a form of remuneration that is tied to firm performance and is also known as bonus schemes. Remuneration depends on the profits of the firm. Short-term focused remuneration is those forms of remuneration that are expected to be settled wholly before twelve months after the end of the annual reporting period in which employees render the related services.
Example of short-term focused remuneration, according to the Australian Accounting Standards, includes the annual leave as an example of short-term focused remuneration. Such remuneration is explicitly dependent on accounting earnings. This is because the nature of short term focused remuneration plans motivate management to select accrual and accounting procedures that maximize the present value of the CEOs bonus. This implies that any modification of a bonus scheme has a high likelihood of causing changes in accounting procedures. Earnings manipulation, which is one of the causes of fraud, depends mainly on the maximization of short-term bonus value (Mehran, 1995).
Explain the CEOs’ and executives’ preference for “short-term focused” remuneration in terms of the management bonus hypothesis. Your answer needs to emphasise both efficiency and opportunistic perspectives.
The CEOs’ and executives’ preference for “short-term focused” remuneration in terms of the management bonus hypothesis is an important factor that every owner or principal must put into consideration. According to management bonus hypothesis, remuneration is designed to motivate CEOs to improve firm’s performance and to align the interests of management with those of the owners or principals (Mehran, 1995). The hypothesis, believes that CEOs who earn very little remuneration are more likely to maximize their own wealth at the expense of the owners or principal. The management bonus hypothesis is based on two perspectives. The first perspective is called efficiency perspective.
According to this perspective, the principals often put in plae strategies to minimize future agency and contracting costs. According to this perspective, it is believed that managers tend to select accounting methods which most efficiently reflect underlying firm performance. This perspective is easily affected by regulations. This is because regulations may impose unwarranted costs and introduces efficiencies. The second perspective is called opportunistic perspective. This is normally implemented once the contract is already in place. This perspective believes that despite the fact that particular accounting methods might initially be selected for efficiency reasons, the managers are likely to utilize accounting choices in a way that best serves their own interest Jensen, M.C. and Murphy 1990) . Consequently, according to this perspective, managers are assumed to opportunistically act to maximize own wealth.
The article says that, “Mr. Bassat blamed risk aversion among corporate leaders too focused on short-term noise for the lack of examples of business taking ideas into Asia”.
According to the article, “Mr. Bassat blamed risk aversion among corporate leaders too focused on short-term noise for the lack of examples of business taking ideas into Asia”. It is true that the lack of enough and good information can force corporate leaders to engage in risk aversion strategies.
The reason is that focusing on short-term noise is likely to compel the principal or rather the corporate leaders to conclude that the investment is not worthwhile. However, this is not necessarily the case because according to the agency theory, the success of agent-principal relationship is determined by the agency relationship. If the agency relationship is close, then the chances of CEO or manager participating in opportunistic acts are low.
However, when the agent is not motivated to work in the best interests of principal, the agent would be forced to engage in activities that would lower the value of the organization.This means that instead of taking part in risk aversion, the corporate leaders should have taken the incentive of motivating the CEOs to work in the best interest
of the principal.
During an interview Mr. Bassat claimed that “It seems if CEOs make a mistake now for the most part they lose their job. It seems to be easier for the just to do nothing”.
The assertion that “It seems if CEOs make a mistake now for the most part they lose their job. It seems to be easier for the just to do nothing”. Indicates that there is horizon problem. The reason for such statement is that CEOs can force a company to collapse not because of lack of efficiency, but because of intention to acquire own wealth. Doing nothing is even considered better because the company would not face much problem such as fraud.
The foregoing discussion has proven that accounting theories and framework are crucial elements that investors must consider when planning to venture into a given investment. It is apparent that CEOs, corporate leaders and managers should rely on the accounting theories in decision making processes.