Accounting exa

Sample is attachedTotal 4 questions. Need 600 words each.Due in 100 minExa is at 4 am est
ATTACHED FILE(S)

UL19/0075
Page 1 of 5

THIS PAPER IS NOT TO BE REMOVED FROM THE EXAMINATION HALL

AC3193ZA

BSc DEGREES AND GRADUATE DIPLOMAS IN ECONOMICS, MANAGEMENT,
FINANCE AND THE SOCIAL SCIENCES, THE DIPLOMA IN ECONOMICS AND
SOCIAL SCIENCES AND THE CERTIFICATE IN EDUCATION IN SOCIAL
SCIENCES

Accounting Theory

Tuesday 7 May 2019: 10.00 – 13.00

Time allowed: 3 hours

DO NOT TURN OVER UNTIL TOLD TO BEGIN

Candidates should answer FOUR of the following EIGHT questions: TWO from
Section A and TWO from Section B. All questions carry equal marks. If you answer
more than two from any section, only the first two answers will be marked.

Workings should be submitted for all questions requiring calculations. Any necessary
assumptions introduced in answering a question are to be stated.

Extracts from compound interest tables are given after the final question on this paper.

A handheld calculator may be used when answering questions on this paper and it
must comply in all respects with the specification given with your Admission Notice.
The make and type of machine must be clearly stated on the front cover of the answer
book.

© University of London 2019

UL19/0075
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Section A

Answer any TWO questions from this section.

1. SandyMandy Ltd is a company that specialises in the disposal of construction
waste. The company does not find it useful to rely on modified historical cost values
and is considering alternative valuations of its non-current assets. The company’s
accountant has collected a range of values on three of its lorries (non-current
assets). The information is presented in the table below:

SandyMandy LtdTruck P Truck Q Truck R
£ £ £
Historical cost of asset84,600 274,000 153,800
Annual depreciation rate 10% 10% 10%
Expected sales value net of all selling costs57,000 132,400 143,000
Current purchase price of an asset in a
similar condition95,000 299,000 235,600

The following additional notes on the three lorries may be relevant:

 Truck P is used as a stand-by vehicle for when other lorries are off the road due to
breakdowns or scheduled maintenance. If the use of Truck P was not available it
is estimated that SandyMandy Ltd would have to spend £24,300 per annum to rent
an equivalent truck from another firm. Annual maintenance costs for Truck P is
£19,600. It is expected that a stand-by facility will be continuously offered to ensure
that the company is able to operate even when its vehicles are off the road.

 Truck Q is one of the company’s regularly used vehicles. It has an expected life of
12 years and the company is able to generate £38,500 annually during its expected
life from the use of this asset.

 Truck R is another of the company’s frequently used vehicles. It has an expected
life of 8 years and is able to generate £35,000 annually for the span of its expected
life.

The company’s expected return on capital invested is 10%.

Required:

a) What is deprival value? Critically assess the usefulness of deprival value for a
company like SandyMandy Ltd.
(11 marks)

b) Calculate the deprival value for Trucks P, Q and R to the nearest £1. You should
ignore the effects of taxation.
(14 marks)

(Total: 25 marks)

UL19/0075
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2. Compare, contrast and critically evaluate two alternative ‘positive / descriptive’
theories of accounting regulation in practice.
(25 marks)

3. Describe and critically evaluate Chua’s (1986) attempt to classify different
approaches to the development of accounting theories.
(25 marks)

4. What type of accounting theory might be understood as critical? Give examples
of critical approaches and assess their contribution to accounting theory.
(25 marks)

Section B

Answer any TWO questions from this section.

5. In relation to management control, what is the issue of myopia and how does it
arise? How might one attempt to resolve this myopia problem?
(25 marks)

6. How does the type of organisational unit or business context impact upon the
method of setting budget targets? What issues are relevant in setting the difficulty
level of targets?
(25 marks)

7. How should management control systems be adapted in the context of a
company expanding into a new environment?
(25 marks)

8. Outline the strengths and limitations of using market-based measures of
performance in the context of management control.
(25 marks)

END OF PAPER

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Present Value interest factor per £1.00 due at the end of n years for interest rate of:
% 1 2 3 4 5 6 7 8 9 10
n
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751
4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683
5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621
6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564
7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513
8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467
9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386
11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350
12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319
13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290
14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263
15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239
16 0.853 0.728 0.623 0.534 0.458 0.394 0.339 0.292 0.252 0.218
17 0.844 0.714 0.605 0.513 0.436 0.371 0.317 0.270 0.231 0.198
18 0.836 0.700 0.587 0.494 0.416 0.350 0.296 0.250 0.212 0.180
19 0.828 0.686 0.570 0.475 0.396 0.331 0.277 0.232 0.194 0.164
20 0.820 0.673 0.554 0.456 0.377 0.312 0.258 0.215 0.178 0.149
21 0.811 0.660 0.538 0.439 0.359 0.294 0.242 0.199 0.164 0.135
22 0.803 0.647 0.522 0.422 0.342 0.278 0.226 0.184 0.150 0.123
23 0.795 0.634 0.507 0.406 0.326 0.262 0.211 0.170 0.138 0.112
24 0.788 0.622 0.492 0.390 0.310 0.247 0.197 0.158 0.126 0.102
25 0.780 0.610 0.478 0.375 0.295 0.233 0.184 0.146 0.116 0.092

% 11 12 13 14 15 16 17 18 19 20
n
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833
2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694
3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579
4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482
5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402
6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335
7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279
8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233
9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194
10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162
11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135
12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112
13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093
14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078
15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.074 0.065
16 0.188 0.163 0.141 0.123 0.107 0.093 0.081 0.071 0.062 0.054
17 0.170 0.146 0.125 0.108 0.093 0.080 0.069 0.060 0.052 0.045
18 0.153 0.130 0.111 0.095 0.081 0.069 0.059 0.051 0.044 0.038
19 0.138 0.116 0.098 0.083 0.070 0.060 0.051 0.043 0.037 0.031
20 0.124 0.104 0.087 0.073 0.061 0.051 0.043 0.037 0.031 0.026
21 0.112 0.093 0.077 0.064 0.053 0.044 0.037 0.031 0.026 0.022
22 0.101 0.083 0.068 0.056 0.046 0.038 0.032 0.026 0.022 0.018
23 0.091 0.074 0.060 0.049 0.040 0.033 0.027 0.022 0.018 0.015
24 0.082 0.066 0.053 0.043 0.035 0.028 0.023 0.019 0.015 0.013
25 0.074 0.059 0.047 0.038 0.030 0.024 0.020 0.016 0.013 0.010

UL19/0075
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Present Value interest factor for an annuity of £1.00 for a series of n years for interest
rate of:
% 1 2 3 4 5 6 7 8 9 10
n
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791
6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355
7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868
8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145
11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495
12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814
13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103
14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367
15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606
16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.824
17 15.562 14.292 13.166 12.166 11.274 10.477 9.763 9.122 8.544 8.022
18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.201
19 17.226 15.678 14.324 13.134 12.085 11.158 10.336 9.604 8.950 8.365
20 18.046 16.351 14.877 13.590 12.462 11.470 10.594 9.818 9.129 8.514
21 18.857 17.011 15.415 14.029 12.821 11.764 10.836 10.017 9.292 8.649
22 19.660 17.658 15.937 14.451 13.163 12.042 11.061 10.201 9.442 8.772
23 20.456 18.292 16.444 14.857 13.489 12.303 11.272 10.371 9.580 8.883
24 21.243 18.914 16.936 15.247 13.799 12.550 11.469 10.529 9.707 8.985
25 22.023 19.523 17.413 15.622 14.094 12.783 11.654 10.675 9.823 9.077

% 11 12 13 14 15 16 17 18 19 20
n
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833
2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528
3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106
4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589
5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991
6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326
7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605
8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837
9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031
10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192
11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327
12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 4.793 4.611 4.439
13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533
14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611
15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675
16 7.379 6.974 6.604 6.265 5.954 5.668 5.405 5.162 4.938 4.730
17 7.549 7.120 6.729 6.373 6.047 5.749 5.475 5.222 4.990 4.775
18 7.702 7.250 6.840 6.467 6.128 5.818 5.534 5.273 5.033 4.812
19 7.839 7.366 6.938 6.550 6.198 5.877 5.584 5.316 5.070 4.843
20 7.963 7.469 7.025 6.623 6.259 5.929 5.628 5.353 5.101 4.870
21 8.075 7.562 7.102 6.687 6.312 5.973 5.665 5.384 5.127 4.891
22 8.176 7.645 7.170 6.743 6.359 6.011 5.696 5.410 5.149 4.909
23 8.266 7.718 7.230 6.792 6.399 6.044 5.723 5.432 5.167 4.925
24 8.348 7.784 7.283 6.835 6.434 6.073 5.746 5.451 5.182 4.937
25 8.422 7.843 7.330 6.873 6.464 6.097 5.766 5.467 5.195 4.948

Accounting: markets and
organisations
J. Haslam, D. Chow and A. Nayak
AC3193
2021
Undergraduate study in Economics,
Management, Finance and the Social
Sciences
This subject guide is for a 300 course offered as part of the University of London
undergraduate study in Economics, Management, Finance and the Social
Sciences. This is equivalent to Level 6 within the Framework for Higher Education
Qualifications in England, Wales and Northern Ireland (FHEQ). For more information,
see: www.london.ac.uk
This guide was prepared for the University of London by:
Professor J. Haslam, Sheffield University, Dr D.Chow, Durham University and Amanda Nyak
MSc FCCA.
This is one of a series of subject guides published by the University. We regret that due to
pressure of work the authors are unable to enter into any correspondence relating to, or
arising from, the guide.

University of London
Publications Office
Stewart House
32 Russell Square
London WC1B 5DN
United Kingdom
london.ac.uk
Published by: University of London
© University of London 2018 reprinted with minor revisions 2021
The University of London asserts copyright over all material in this subject guide except where
otherwise indicated. All rights reserved. No part of this work may be reproduced in any form,
or by any means, without permission in writing from the publisher. We make every effort to
respect copyright. If you think we have inadvertently used your copyright material, please let
us know.
https://london.ac.uk/
Contents
i
Contents
Chapter 1: Introduction ……………………………………………………………………………… 1
1.1 Introduction ……………………………………………………………………………………………… 1
1.2 Syllabus ……………………………………………………………………………………………………. 1
1.3 Aims of the course ……………………………………………………………………………………… 2
1.4 Learning outcomes for the course …………………………………………………………………. 2
1.5 Introduction to the subject area ……………………………………………………………………. 2
1.6 Route map to the guide ………………………………………………………………………………. 3
1.7 Overview of learning resources …………………………………………………………………….. 4
1.8 The examination ………………………………………………………………………………………… 7
Chapter 2: Introducing accounting theory ………………………………………………….. 11
2.1 Introduction ……………………………………………………………………………………………. 11
2.2 Introducing accounting theory ……………………………………………………………………. 12
2.3 Positive/descriptive vs normative/prescriptive theorising of accounting ……………….. 12
2.4 Notions of inductive and deductive theorising in accounting and other
categorisations of theorising ……………………………………………………………………………. 15
2.5 Overview of chapter …………………………………………………………………………………. 17
2.6 Reminder of learning outcomes…………………………………………………………………… 18
2.7 Test your knowledge and understanding ………………………………………………………. 18
2.8 Sample examination questions ……………………………………………………………………. 18
Chapter 3: Economist’s interpretation of income measurement and capital
measurement ………………………………………………………………………………………….. 19
3.1 Introduction ……………………………………………………………………………………………. 19
3.2 A view of income and capital often characterised as the accountant’s view …………. 19
3.3 A view of income and capital often characterised as the economist’s view ………….. 20
3.4 Hicks’s version of the economist’s concept of income ………………………………………. 21
3.5 Hicks’s income number 1 …………………………………………………………………………… 21
3.6 Income ex ante and income ex post …………………………………………………………….. 25
3.7 What if interest rates are expected to change? ………………………………………………. 28
3.8 Hicks’s income number 2 …………………………………………………………………………… 30
3.9 Hicks’s income number 3 …………………………………………………………………………… 34
3.10 Implications of Hicks’s measures of income …………………………………………………. 34
3.11 Implications for accountants …………………………………………………………………….. 35
3.12 Reminder of learning outcomes…………………………………………………………………. 36
3.13 Sample examination questions ………………………………………………………………… 36
Chapter 4: Accounting for changing prices/values ……………………………………….. 37
4.1 Introduction ……………………………………………………………………………………………. 37
4.2 Introduction to current value accounting (CVA) ……………………………………………… 38
4.3 Worked example and explanation of CVA ……………………………………………………… 38
4.4 Combined CPP/CVA system ……………………………………………………………………….. 42
4.5 Reminder of learning outcomes…………………………………………………………………… 47
4.6 Sample examination question …………………………………………………………………….. 47
Chapter 5: Deprival value …………………………………………………………………………. 49
5.1 Introduction ……………………………………………………………………………………………. 49
5.2 Deprival value ………………………………………………………………………………………….. 49
5.3 Conceptualising replacement costs in DV ……………………………………………………… 52
AC3193 Accounting theory
ii
5.4 Advantages and disadvantages of deprival value ……………………………………………. 56
5.5 Reminder of learning outcomes…………………………………………………………………… 57
5.6 Sample examination question …………………………………………………………………….. 58
Chapter 6: Positive/descriptive economistic theory of accounting …………………. 59
6.1 Introduction ……………………………………………………………………………………………. 59
6.2 Historical context ……………………………………………………………………………………… 60
6.3 The character of positive/descriptive economistic accounting theory …………………… 61
6.4 Theories linking accounting with the notion of efficient markets ………………………… 61
6.5 Other studies …………………………………………………………………………………………… 63
6.6 Critique ………………………………………………………………………………………………….. 65
6.7 Overview of chapter …………………………………………………………………………………. 66
6.8 Reminder of learning outcomes…………………………………………………………………… 66
6.9 Test your knowledge and understanding ………………………………………………………. 67
6.10 Sample examination questions ………………………………………………………………….. 67
Chapter 7: Theorising accounting through an interpretive approach ……………… 69
7.1 Introduction ……………………………………………………………………………………………. 69
7.2 The basic character of interpretive accounting theory ………………………………………. 71
7.3 Relatively early interpretive accounting theory contributions …………………………….. 72
7.4 More recent variants of interpretive accounting theory ……………………………………. 72
7.5 Critique ………………………………………………………………………………………………….. 75
7.6 Overview of chapter …………………………………………………………………………………. 76
7.7 Reminder of learning outcomes…………………………………………………………………… 76
7.8 Test your knowledge and understanding ………………………………………………………. 76
7.9 Sample examination questions ……………………………………………………………………. 76
Chapter 8: Critical accounting theory ………………………………………………………… 79
8.1 Introduction ……………………………………………………………………………………………. 79
8.2 Delineation of critical accounting theory ……………………………………………………….. 80
8.3 Some themes of critical accounting theorising: too negative?………………………….. 81
8.4 Critique ………………………………………………………………………………………………….. 83
8.5 Overview of chapter …………………………………………………………………………………. 84
8.6 Reminder of learning outcomes…………………………………………………………………… 84
8.7 Test your knowledge and understanding ………………………………………………………. 84
8.8 Sample examination questions ……………………………………………………………………. 84
Chapter 9: Theorising of accounting regulation I: normative/prescriptive
theorising……………………………………………………………………………………………… 85
9.1 Introduction ……………………………………………………………………………………………. 85
9.2 Accounting regulation: context ……………………………………………………………………. 86
9.3 Prescriptive theory and accounting standards ………………………………………………… 87
9.4 Some regulatory implications ……………………………………………………………………… 89
9.5 Overview of chapter …………………………………………………………………………………. 93
9.6 Reminder of learning outcomes…………………………………………………………………… 93
9.7 Test your knowledge and understanding ………………………………………………………. 93
9.8 Sample examination questions ……………………………………………………………………. 93
Chapter 10: Theorising of accounting regulation II: positive/descriptive
theorising ………………………………………………………………………………………………. 95
10.1 Introduction ………………………………………………………………………………………….. 95
10.2 Positive/descriptive theorising of accounting regulation that has emphasised
the economistic …………………………………………………………………………………………….. 97
10.3 Accounting regulation from a political economy perspective …………………………… 99
10.4 Cultural and institutional ways of seeing accounting regulation …………………….. 100
Contents
iii
10.5 Ideologies and rhetoric of accounting regulation ………………………………………… 100
10.6 Studying the interface between the global and national ………………………………. 101
10.7 Overview of chapter ……………………………………………………………………………… 102
10.8 Reminder of learning outcomes……………………………………………………………….. 102
10.9 Test your knowledge and understanding …………………………………………………… 102
10.10 Sample examination questions ………………………………………………………………. 102
Part 2: Management accounting ……………………………………………………………… 103
Introduction ……………………………………………………………………………………………….. 103
Organising your studies ………………………………………………………………………………… 103
Chapter 11: Introduction to control systems – personnel controls, cultural
controls, action controls and results controls ……………………………………………. 105
11.1 Introduction ………………………………………………………………………………………… 105
11.2 The importance of management control ……………………………………………………. 106
11.3 Causes of management control problems…………………………………………………. 110
11.4 Action, personnel and cultural controls ……………………………………………………… 111
11.5 Results controls…………………………………………………………………………………… 115
11.6 Conditions needed to implement effective results controls ……………………………. 116
11.7 Reminder of learning outcomes……………………………………………………………….. 117
11.8 Case studies ………………………………………………………………………………………… 117
11.9 Test your knowledge and understanding …………………………………………………… 117
Chapter 12: Control system tightness and control system costs ………………….. 119
12.1 Introduction ………………………………………………………………………………………… 119
12.2 Control system tightness ………………………………………………………………………… 120
12.3 Control system costs ……………………………………………………………………………… 124
12.4 Adaptation of control systems …………………………………………………………………. 128
12.5 Summary …………………………………………………………………………………………….. 129
12.6 Reminder of learning outcomes……………………………………………………………….. 129
12.7 Case study ………………………………………………………………………………………….. 130
12.8 Test your knowledge and understanding …………………………………………………… 130
Chapter 13: Designing and evaluating management control systems.
Identifying financial responsibility centres ……………………………………………….. 131
13.1 Introduction ………………………………………………………………………………………… 131
13.2 Designing and evaluating management control systems (MCS) ……………………… 132
13.3 Identifying financial responsibility centres and transfer pricing methods ………….. 134
13.4 Transfer pricing …………………………………………………………………………………….. 137
13.5 Methods of setting transfer prices ……………………………………………………………. 138
13.6 Reminder of learning outcomes……………………………………………………………….. 141
13.7 Case study ………………………………………………………………………………………….. 141
13.8 Test your knowledge and understanding …………………………………………………… 142
Chapter 14: A detailed look at planning and budgeting ……………………………… 143
14.1 Introduction ………………………………………………………………………………………… 143
14.2 Budget purposes ………………………………………………………………………………….. 143
14.3 Planning cycles …………………………………………………………………………………….. 144
14.4. Target setting ………………………………………………………………………………………. 145
14.5 Recasting the budget …………………………………………………………………………….. 146
14.6 Common financial performance target issues …………………………………………….. 146
14.6 Criticisms of budgeting and consideration of beyond budgeting …………………….. 148
14.7 Reminder of learning outcomes……………………………………………………………….. 149
14.8 Case study ………………………………………………………………………………………….. 149
14.9 Test your knowledge and understanding …………………………………………………… 149
AC3193 Accounting theory
iv
Chapter 15: Incentive systems ………………………………………………………………… 151
15.1 Introduction ………………………………………………………………………………………… 151
15.2 Purposes and types of incentives ……………………………………………………………… 151
15.3 Monetary incentives ……………………………………………………………………………… 152
15.4 Incentive scheme design ………………………………………………………………………… 154
15.5 Incentive formulas and subjective rewards …………………………………………………. 154
15.6 The shape of the incentive function ………………………………………………………….. 155
15.7 Criteria for evaluating incentive systems ……………………………………………………. 156
15.8 Group rewards …………………………………………………………………………………….. 156
15.9 Reminder of learning outcomes……………………………………………………………….. 157
15.10 Case study ………………………………………………………………………………………… 157
15.11 Test your knowledge and understanding …………………………………………………. 157
Chapter 16: Financial performance measures and their effects …………………… 159
16.1 Introduction ………………………………………………………………………………………… 159
16.2 Using market measures of performance for managerial appraisal …………………… 160
16.3 Using accounting measures of performance for managerial appraisal ……………… 161
16.4 Reminder of learning outcomes……………………………………………………………….. 166
16.5 Case study ………………………………………………………………………………………….. 166
16.6 Test your knowledge and understanding …………………………………………………… 167
Chapter 17: Remedies to the myopia problem ………………………………………….. 169
17.1 Introduction ………………………………………………………………………………………… 169
17.2 Pressures to act myopically …………………………………………………………………….. 169
17.3 Ways to decrease myopia ……………………………………………………………………….. 170
17.4 Strengths of several performance measures ……………………………………………….. 174
17.5 Issues in creating the correct measures …………………………………………………….. 175
17.6 Reminder of learning outcomes……………………………………………………………….. 175
17.7 Case study ………………………………………………………………………………………….. 176
17.8 Test your knowledge and understanding …………………………………………………… 176
Chapter 18: Using financial results controls in the presence of uncontrollable
factors …………………………………………………………………………………………………. 177
18.1 Introduction ………………………………………………………………………………………… 177
18.2 The controllability principle …………………………………………………………………….. 177
18.3 Deciding on whether factors are uncontrollable ………………………………………….. 178
18.4 Controlling for the distorting effects of uncontrollables ………………………………… 179
18.5 Methods which can be used to determine the impact of the event …………………. 180
18.6 Reminder of learning outcomes……………………………………………………………….. 182
18.7 Case study ………………………………………………………………………………………….. 182
18.8 Test your knowledge and understanding …………………………………………………… 182
Chapter 19: Management control-related ethical issues …………………………….. 183
19.1 Introduction ………………………………………………………………………………………… 183
19.2 Ethical behaviour in a business context …………………………………………………….. 184
19.3 Ethical models ……………………………………………………………………………………… 184
19.4 Analysing ethical issues …………………………………………………………………………. 185
19.5 Some management control-related ethical issues ……………………………………….. 186
19.6 Reminder of learning outcomes……………………………………………………………….. 188
19.7 Case study ………………………………………………………………………………………….. 188
19.8 Test your knowledge and understanding …………………………………………………… 188
Chapter 20: Management control in not-for-profit organisations ………………… 189
20.1 Introduction ………………………………………………………………………………………… 189
20.2 Types of not-for-profit organisation ………………………………………………………….. 189
Contents
v
20.3 Key similarities and differences in management control between for-profit and
not-for-profit organisations ……………………………………………………………………………. 191
20.4 Not-for-profit budgeting ………………………………………………………………………… 191
20.5 Difficulties in measuring and rewarding performance …………………………………… 193
20.6 Accounting differences …………………………………………………………………………… 194
20.7 External scrutiny …………………………………………………………………………………… 194
20.8 Public sector scorecard ………………………………………………………………………….. 195
20.9 Employment characteristics …………………………………………………………………….. 196
20.10 Summary …………………………………………………………………………………………… 196
20.11 Reminder of learning outcomes……………………………………………………………… 196
20.12 Test your knowledge and understanding …………………………………………………. 197
Appendix 1: Solutions to activities and sample examination questions………… 199
Note to students ………………………………………………………………………………………….. 199
Chapter 3 …………………………………………………………………………………………………… 199
Chapter 4 …………………………………………………………………………………………………… 200
Chapter 5 …………………………………………………………………………………………………… 202
Notes
AC3193 Accounting theory
vi
Chapter 1: Introduction
1
Chapter 1: Introduction
1.1 Introduction
Welcome to the course AC3193 Accounting theory. An appreciation
of both academic discourse in accounting and accounting in practice
requires an appreciation of theory. For example, in respect of accounting
in practice, the conceptual frameworks prescribed by policy-makers are
types of theory. Similarly, the management accounting techniques covered
in introductory texts on accounting are reflective of a theoretical position.
Being able to understand instances of accounting practice properly
involves the utilisation of theory. In this context, accounting theory has
expanded and become more complex in recent times as an array of
theories have emerged to help explain or prescribe accounting practice.
This chapter aims to provide a brief overview of the chapters in the subject
guide, which concerns both financial and management accounting. This
chapter outlines the theoretical character of the module and shows how
the module builds on AC2091 Financial reporting and AC2097
Management accounting.
1.2 Syllabus
This subject guide is divided into two parts – Part 1: Chapters 2–10 and
Part 2: Chapters 11–20.
• Chapter 1 provides an introduction to AC3193 Accounting theory.
• Chapters 2 to 5 focus on normative (prescriptive) economistic theories
of accounting, such as current entry and exit value systems, deprival
value and Hicks’s income.
• Chapter 6 discusses positive (descriptive) economistic theories of
accounting that make use of key archival databases, such as the
efficient markets hypothesis and Watts and Zimmerman’s ‘positive’
accounting theory.
• Chapter 7 discusses positive (descriptive) socio-political/social theories
of accounting (interpretive accounting theory).
• Chapter 8 covers critical approaches in accounting.
• Chapters 9 and 10 deal with the regulation of external accounting.
• Chapter 11 introduces management control, identifying results control,
action, personnel and cultural controls.
• Chapter 12 discusses control system tightness and costs, and designing
and evaluating management control systems.
• Chapter 13 focuses on financial responsibility centres.
• Chapter 14 reviews planning and budgeting, including variations and
problems
• Chapter 15 looks at issues relating to incentive compensation.
• Chapter 16 considers the effects of financial performance measures.
• Chapter 17 incorporates combinations of measures and other remedies
and using financial results in the presence of uncontrollable factors.
• Chapter 18 considers the related ethical issues of management control.
AC3193 Accounting theory
2
• Chapter 19 looks at the effects of environmental uncertainty,
organisational structure and multi-nationality on management control
systems.
• Chapter 20 considers management control in non-profit organisations.
The up-to-date course syllabus for AC3193 Accounting theory can be
found in the course information sheet, which is available on the course
VLE (virtual learning environment) page or on the LSE website: www.lse.
ac.uk/study-at-lse/uolip/course-information-sheets
1.3 Aims of the course
Part 1 of this course aims to develop students’ ability to critically evaluate
financial accounting theories and their impacts on recent development in
accounting practices.
Part 2 addresses issues in management accounting and organisational
control, including: financial and other controls, organisational structures,
performance measurement and incentive systems, budgetary control
and public-sector and non-profit financial management within the
organisational and human behavioural context.
1.4 Learning outcomes for the course
At the end of the course and having completed the Essential reading and
activities, you should be able to:
• critically assess the impact of positive and normative accounting
theories and their applications in dealing with complex financial
accounting issues such as alternative accounting conventions,
conceptual framework and economic income approach.
• discuss the different approaches in regulating financial accounting
information
• discuss the demand and implications of financial information in capital
market research
• evaluate the applications of sociological and organisational approaches
to the study of accounting
• evaluate issues arising from management control in its organisational
context
• discuss various approaches to performance measurement and control
in various types of organisations, and devise and evaluate indicators of
performance
• discuss contingency theory and its impacts on management control
practices in organisations
• discuss the ethical issues of using management control methods and its
use in non-profit organisations.
1.5 Introduction to the subject area
This module builds on the previous modules AC2091 Financial
reporting and AC2097 Management accounting. It does this by
exploring theories that have been used to shape external accounting and
management accounting. We will look at theories that have been mobilised
to theorise external accounting and management accounting in action or
as found in practice.
http://www.lse.ac.uk/study-at-lse/uolip/course-information-sheets
http://www.lse.ac.uk/study-at-lse/uolip/course-information-sheets
Chapter 1: Introduction
3
In addition, the module provides for more expansive and developed
treatment of some areas, such as accounting for changing prices and
current value systems. It also includes further appreciation of shifts in
accounting principles and policies over time.
1.6 Route map to the guide
Chapter 1 is the introductory chapter.
Chapters 2 to 9 focus upon external accounting.
Chapter 2 introduces accounting theory. The distinction that is
commonly made in the social sciences between, on the one hand,
positive (descriptive) theory and, on the other hand, normative
(prescriptive) theory is articulated. Other categories of theory are
elaborated within the latter broad category of positive theory, including
notions of open/closed theory, critical/conservative theory and
subjectivist/objectivist theory. As well as instances of prescriptive/
normative theory, instances of descriptive/positive theory are discussed in
the guide under three headings: positive/descriptive economistic theory
of accounting; interpretive theory of accounting at the interface with the
social; critical accounting theory.
Chapter 3 elaborates upon and discusses normative (prescriptive)
attempts to represent income and capital (and capital maintenance).
The focus in Chapter 3 is on normative theorising of accounting through
a (mainstream) economic lens (which has been very influential in
accounting theory). Prominent here is discussion of Hicks’s theorising of
income. Illustrations are included.
Chapter 4 continues the focus upon prescriptive/normative accounting
theory, again taking the case of that theory which substantively views
the phenomenon of accounting through an economic lens. The chapter
elaborates upon and discusses prescriptive/normative attempts to reflect
inflation and current values in external financial accounting. Analysis in
AC2091 is here extended to include topics such as fully stabilised current
value accounts (FSCVA), which attempts to combine current purchasing
power (CPP) accounting with current value accounting (CVA). Illustrations
are again included.
Continuing the same broad and economistic theoretical focus of Chapters
3 and 4, Chapter 5 elaborates upon and discusses deprival value
accounting as a particular kind of CVA that may in principle be used in
external financial accounting. Illustrations of this type of accounting are
included in the chapter. In appraising deprival value, its relevance for
resolving issues of income definition raised by Hicks (and considered in
Chapter 3 of this subject guide) is discussed.
Chapter 6 shifts emphasis away from normative/prescriptive theory
in accounting and begins to elaborate upon contributions to building
positive/descriptive theory of accounting. Chapter 6 again focuses on
more economistic theorising. Positive/descriptive theorising of accounting
with an economistic emphasis is a major constituent of the accounting
literature. The theory, with its several strands, has been substantively
built through the empirical analysis of financial accounting in relation to
other phenomena (such as prices of company shares on stock exchange
markets) using research methods popular in what is commonly referred
to in economics as positive economic theory. These research methods are
substantively quantitative and involve large data samples (typically drawn
from established databases) and statistical analysis. We cover a range of
theories here that are all consistent with this type of theorising. Instances
AC3193 Accounting theory
4
of the theories generated in this tradition of research are discussed and a
critical appraisal of this type of theorising is articulated.
Chapter 7 explores the theorising that has been understood, articulated
and promoted as interpretive theory of accounting, in relation to the
social. Accounting is theorised ‘in action’ in the context of which it is part.
Methods of a more qualitative research design, such as single case studies,
are here used to seek in-depth insight. Instances of these theories are
discussed and a critical appraisal of this type of theorising is articulated.
Chapter 8 considers critical accounting theory. We seek to articulate
the meaning or meanings of critical accounting theory in the literature.
Instances of such theorising are discussed and a critical appraisal of this
type of theorising is articulated.
Chapters 9 and 10 give attention to the topic of (external) accounting
regulation, drawing upon theories or ways of seeing considered in earlier
chapters.
Chapters 11 to 20 focus on management accounting (introduced
further before Chapter 11).
1.7 Overview of learning resources
1.7.1 The subject guide
The goal of this subject guide is to provide you with an overview of the
topics covered in this course. To begin with, you should first read through
the chapter quickly before reading the Essential readings, and then return
to the subject guide chapter for a closer examination of its content. Each
chapter’s learning outcomes are there to provide you with a checklist of
subjects you should have mastered before moving on to the next chapter.
The reading for this course is divided into two categories: Essential and
Further. You will be given online access to the Essential publications
(individual book chapters, journal articles, etc.) either via the Online
Library or through PDFs uploaded to the VLE. You are not required to
access or buy the Further readings, but they may prove helpful to you in
your study.
1.7.2 Essential reading
The Essential reading for Chapters 1–10 is:
Alexander, D., A. Britton, A. Jorissen, M. Hoogendoorn and C.V. Mourik
International financial reporting and analysis. (Andover: Cengage Learning
EMEA, 2017) 7th edition [ISBN 9781473725454] Chapters 4, 5, 6 and 12.
Deegan, C. and J. Unerman Financial accounting theory. (Maidenhead:
McGraw-Hill Education, 2011) 2nd edition [ISBN 9780077126735]
Chapters 1 and 3.
Jones, S. (ed.) The Routledge companion to financial accounting theory. (London:
Routledge, 2015) [ISBN 9781135107253] Chapter 18.
Roslender, R. (ed.) The Routledge companion to critical accounting. (London:
Routledge, 2018) [ISBN 9781317686736] Chapters 1, 2 and 11.
For Chapters 11–20, the Essential reading is:
Merchant, K.A. and W.A. Van der Stede Management control systems:
Performance measurement, evaluation and incentives. (Harlow: Pearson,
2017) 4th edition [ISBN 9781292110554] Chapters 1–12, 15 and 16.
In addition to the main textbook, there are several key journal articles
that you are required to read, which you will find listed for each individual
chapter.
Chapter 1: Introduction
5
Detailed reading references in this subject guide refer to the editions of the
set textbooks listed above. New editions of one or more of these textbooks
may have been published by the time you study this course. You can use
a more recent edition of any of the books; use the detailed chapter and
section headings and the index to identify relevant readings. Also check
the VLE regularly for updated guidance on readings.
1.7.3 Further reading
Please note that as long as you read the Essential reading you are then free
to read around the subject area in any text, paper or online resource. You
will need to support your learning by reading as widely as possible and by
thinking about how these principles apply in the real world. To help you
read extensively, you have free access to the VLE and University of London
Online Library (see below).
Other useful texts for this course include:
Gallhofer, S. and J. Haslam Accounting and emancipation: some critical
interventions. (New York, NY: Routledge, 2003) [ISBN 9780415220149].
Godfrey, J., A. Hodgson, A. Tarca, J. Hamilton and S. Holmes Accounting theory.
(Hoboken, NJ: Wiley, 2010) 7th edition [ISBN 9780470818152].
Tinker, T. Paper prophets: a social critique of accounting. (London: Holt, Rinehart
and Winston, 1985) [ISBN 9780039106416].
A full list of all Further reading referred to in the subject guide is
presented here for ease of reference.
Journal articles
Ball, R. and P. Brown ‘An empirical evaluation of accounting income numbers’,
Journal of Accounting Research 6(2) 1968, pp.159–78.
Chua, W.F. ‘Radical developments in accounting thought’, The Accounting Review
61(4) 1986, pp.601–32.
Cooper, D.J. and M.J. Sherer ‘The value of corporate accounting reports –
arguments for a political economy of accounting’, Accounting, Organizations
and Society 9(3/4) 1984, pp.207–32.
Gallhofer, S. and J. Haslam ‘Exploring social, political and economic
dimensions of accounting in the global context: the IASB and accounting
disaggregation’, Socio-Economic Review 8(4) 2007, pp.633–64.
Gallhofer, S., J. Haslam and A. Yonekura ‘Further reflections on a
methodological issues debate in accounting’, Critical Perspectives on
Accounting 24 2013, pp.191–206.
Spence, C. ‘Social accounting’s emancipatory potential: a Gramscian critique’,
Critical Perspectives on Accounting 20(2) 2009, pp.205–27.
Tomkins, C. and R. Groves ‘The everyday accountant and researching his
reality’, Accounting, Organizations and Society 8(4), pp.361–74.
Unerman, J. and M. Bennett ‘Increased stakeholder dialogue and the
internet: towards greater corporate accountability or reinforcing capitalist
hegemony?’, Accounting, Organizations and Society 29(70) 2004,
pp.685–707.
Willmott, H. ‘Paradigms for accounting research: Critical reflections on the
everyday accountant and researching his reality’, Accounting, Organizations
and Society 8(4) 1983, pp.389–405.
Books
Baxter, W.T. Inflation accounting. (Oxford: Philip Allan, 1984) [ISBN
9780860036234] Chapters 3, 8 (pp.103–15) and 12 (pp.182–201).
Beaver, W.H. Financial reporting: an accounting revolution. (Harlow: Prentice-
Hall, 1981) [ISBN 9780133161410] Chapter 7.
Hicks, J.R. Value and capital. (Oxford: Clarendon, 1946) 2nd edition. Chapter 14.
AC3193 Accounting theory
6
Hicks, J.R. ‘Incomes’ in Parker, R.H., G.C. Harcourt and G. Whittington (eds)
Readings in the concepts and measurements of income. (Oxford: Philip Allan,
1986) 2nd edition [ISBN 9780860035367].
Hoque, Z. (ed.) Methodological issues in accounting research: theories and
methods. (London: Spiramus, 2006) [ISBN 9781910151471] Chapters 9
and 10.
Horngren C.T., S.M. Datar and M.V. Rajan Cost accounting: A managerial
emphasis. (Harlow: Pearson Education, 2015) 15th edition [ISBN
9780134475585] Chapter 22.
Ijiri, Y. ‘A defence for historical cost accounting’ in R. Sterling (ed.) Asset
valuation and income determination. (Lawrence, KA: Scholars Book Co.,
1971) [ISBN 9780914348115].
Lewis, R. and D. Pendrill Advanced financial accounting. (Harlow: Financial
Times Prentice-Hall, 2004) 7th edition. [ISBN 9780273658498] Chapter 4.
Roslender, R. ‘Introduction’ in Roslender, R. (ed.) The Routledge companion to
critical accounting. (London: Routledge, 2018) [ISBN 9781317686736].
Roslender, R. ‘Critical theory’ in Hoque, Z. (ed.) Methodological issues in
accounting research: theories and methods. (London: Spiramus, 2006) [ISBN
9781910151471].
Watts, R.L. and J. Zimmerman Positive accounting theory. (Englewood Cliffs,
NJ: Prentice-Hall, 1986) [ISBN 9780136861713].
Whittington, G. Inflation accounting: an introduction to the debate. (Cambridge:
Cambridge University Press, 1983) [ISBN 9780521270557].
1.7.4 Websites
Unless otherwise stated, all websites in this subject guide were accessed in
July 2018. We cannot guarantee, however, that they will stay current and
you may need to perform an internet search to find the relevant pages.
1.7.5 Online study resources
In addition to the subject guide and the Essential reading, it is crucial that
you take advantage of the study resources that are available online for this
course, including the VLE and the Online Library.
You can access the VLE, the Online Library and your University of London
email account via the Student Portal at:
https://my.london.ac.uk
You should have received your login details for the Student Portal with
your official offer, which was emailed to the address that you gave
on your application form. You have probably already logged in to the
Student Portal in order to register! As soon as you registered, you will
automatically have been granted access to the VLE, Online Library and
your fully functional University of London email account.
If you have forgotten these login details, please click on the ‘Forgotten
your password’ link on the login page.
The VLE
The VLE, which complements this subject guide, has been designed to
enhance your learning experience, providing additional support and a
sense of community. It forms an important part of your study experience
with the University of London and you should access it regularly.
The VLE provides a range of resources for EMFSS courses:
• Course materials: Subject guides and other course materials
available for download. In some courses, the content of the subject
guide is transferred into the VLE and additional resources and
activities are integrated with the text.
https://my.london.ac.uk
Chapter 1: Introduction
7
• Readings: Direct links, wherever possible, to essential readings in the
Online Library, including journal articles and ebooks.
• Video content: Including introductions to courses and topics within
courses, interviews, lessons and debates.
• Screencasts: Videos of PowerPoint presentations, animated podcasts
and on-screen worked examples.
• External material: Links out to carefully selected third-party
resources.
• Self-test activities: Multiple-choice, numerical and algebraic
quizzes to check your understanding.
• Collaborative activities: Work with fellow students to build a body
of knowledge.
• Discussion forums: A space where you can share your thoughts
and questions with fellow students. Many forums will be supported by
a ‘course moderator’, a subject expert employed by LSE to facilitate the
discussion and clarify difficult topics.
• Past examination papers: We provide up to three years of past
examinations alongside Examiners’ commentaries that provide guidance
on how to approach the questions.
• Study skills: Expert advice on getting started with your studies,
preparing for examinations and developing your digital literacy skills.
Note: Students registered for Laws courses also receive access to the
dedicated Laws VLE.
Some of these resources are available for certain courses only, but we
are expanding our provision all the time and you should check the VLE
regularly for updates.
Making use of the Online Library
The Online Library (http://onlinelibrary.london.ac.uk) contains a huge
array of journal articles and other resources to help you read widely and
extensively.
You will be able to access the majority of resources via the Online Library
using your Student Portal account name and password.
The easiest way to locate relevant content and journal articles in the
Online Library is to use the Summon search engine.
If you are having trouble finding an article listed in a reading list, try
removing any punctuation from the title, such as single quotation marks,
question marks and colons.
For further advice, please use the online help pages (http://onlinelibrary.
london.ac.uk/resources/summon) or contact the Online Library team:
onlinelibrary@shl.london.ac.uk
1.8 The examination
Important: the information and advice given here are based on the
examination structure used at the time this guide was written. Please
note that subject guides may be used for several years. Because of this
we strongly advise you to always check both the current Programme
regulations for relevant information about the examination, and the VLE
where you should be advised of any forthcoming changes. You should also
carefully check the rubric/instructions on the paper you actually sit and
http://onlinelibrary.london.ac.uk
http://onlinelibrary.london.ac.uk/resources/summon
http://onlinelibrary.london.ac.uk/resources/summon
mailto:onlinelibrary@shl.london.ac.uk
AC3193 Accounting theory
8
follow those instructions.
A full Sample examination paper will be uploaded to the course VLE page.
Remember, it is important to check the VLE for:
• up-to-date information on examination and assessment arrangements
for this course
• where available, past examination papers and Examiners’ commentaries
for the course which give advice on how each question might best be
answered.

9
Part 1: Financial accounting
Welcome to the financial accounting section of AC3193 Accounting
theory. In this section (Chapters 2–10) we will look in detail at financial
accounting theories and their impact on recent developments in
accounting practices.
Notes
AC3193 Accounting theory
10
Chapter 2: Introducing accounting theory
11
Chapter 2: Introducing accounting theory
2.1 Introduction
This chapter introduces accounting theory. It distinguishes between
positive (descriptive) and normative (prescriptive) accounting theory. A
critical approach to accounting theory is discussed.
2.1.1 Aims of the chapter
The aims of this chapter are to:
• introduce accounting theory
• articulate a distinction between prescriptive/normative theory and
descriptive/positive theory
• elaborate and discuss other categories of theory in relation to
accounting.
2.1.2 Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• discuss various types of accounting theory.
2.1.3 Essential reading
Deegan, C. and J. Unerman Financial accounting theory. (Maidenhead:
McGraw-Hill Education, 2011) 2nd edition [ISBN 9780077126735].
Chapter 1.
Laughlin, R. ‘Empirical research in accounting: alternative approaches and a
case for “middle-range” thinking’, Accounting, Auditing and Accountability
Journal 8(1) 1995, pp.63–87.
2.1.4 Further reading
Chua, W.F. ‘Radical developments in accounting thought’, The Accounting Review
61(4) 1986, pp.601–32.
Gallhofer, S., J. Haslam and A. Yonekura ‘Further reflections on a
methodological issues debate in accounting’, Critical Perspectives on
Accounting 24 2013, pp.191–206.
Godfrey, J., A. Hodgson, A. Tarca, J. Hamilton and S. Holmes Accounting theory.
(Hoboken, NJ: Wiley, 2010) 7th edition [ISBN 9780470818152].
Roslender, R. ‘Introduction’ in Roslender, R. (ed.) The Routledge companion to
critical accounting. (London: Routledge, 2018) [ISBN 9781317686736].
Tomkins, C. and R. Groves ‘The everyday accountant and researching his
reality’, Accounting, Organizations and Society 8(4) 1983, pp.361–74.
Willmott, H. ‘Paradigms for accounting research: Critical reflections on the
everyday accountant and researching his reality’, Accounting, Organizations
and Society 8(4) 1983, pp.389–405.
2.1.5 References cited
Bernstein, R. The restructuring of social and political theory. (Oxford: Blackwell,
1976) [ISBN 9780631175902]
Burrell, G. and G. Morgan Sociological paradigms and organisational analysis.
(London: Heinemann, 1979) [ISBN 9780435821319].
Clegg, S. and D. Dunkerley Organization, class and control. (London: Routledge
and Kegan Paul, 1980) [ISBN 9780710004352].
Gallhofer, S. and J. Haslam ‘Reflections on the emancipatory accounting
construct: shifting meaning and the possibilities of a new pragmatism’,
AC3193 Accounting theory
12
Critical Perspectives on Accounting 2017. Advance online publication. doi.
org/10.1016/j.cpa.2017.01.004
Hopper, T. and A. Powell ‘Making sense of research into the organisational
and social aspects of management accounting: a review of its underlying
assumptions’, Journal of Management Studies 22(5) 1985, pp.429–65.
Tomkins, C. and R. Groves ‘The everyday accountant and researching his
reality’, Accounting, Organizations and Society 8(4) 1983, pp.361–74.
Winch, P. The idea of a social science and its relation to philosophy. (London:
Routledge and Kegan Paul, 1958) [ISBN 9780710068040].
2.2 Introducing accounting theory
Accounting theory is sometimes taken to mean something like the way
accounting ‘should be’ (e.g. ‘That is how accounting should be’, ‘That is
what accounting is in theory’ and ‘That is what accounting is supposed
to do in theory’). It might therefore be contrasted with ‘accounting
practice’ or how accounting functions in practice. But ‘the way accounting
should be’ is only one kind of theory of accounting. ‘Accounting practice’
might be better articulated as ‘a theory of accounting practice’, which is
another kind of theory (and we shall see that there are many variants of
such theory). More generally, here we are considering accounting theory
in terms of the theorising of accounting – as is now common in many
accounting theory texts.
The word ‘theory’ is rooted in ancient Greek, where it has the sense of
‘argument’. This remains a useful way of thinking about theory.
Theories can be built or constructed in different ways. This has led to
attempts to classify theories so as to enhance understanding (e.g. Chua,
1986; Laughlin, 1995; Deegan and Unerman, 2011). Note, however,
in this regard, that classification and categorisation inevitably involve
simplification. In particular, classification schemes risk tending to portray
relative differences (differences that are matters of emphasis) as
absolute differences. With that warning or note of caution in mind,
classification schemes are useful for enhancing appreciation of theory.
2.3 Positive/descriptive vs normative/prescriptive
theorising of accounting
Perhaps the most basic categorisation of theories, common in social
sciences, is the distinction between ‘descriptive’ (sometimes called
‘positive’) theories and ‘prescriptive’ (sometimes called ‘normative’)
theories. The constructs of ‘positive’ and ‘normative’ theory are very
familiar ones within the discipline of economics.
Descriptive/positive theories of accounting are seen as trying to
understand accounting ‘as it is’ or ‘as it functions or operates’ in practice.
Such theories might be interested in, for instance, what is understood as
accounting in practice, how accounting is seen, what influences accounting
in practice (e.g. business objectives and practices, laws, professional
standards and wider contextual dimensions such as cultures) and what
consequences it has in practice (e.g. for the economy, the organisation
or society). Such theories could be of accounting in the past (histories of
accounting).
Note that there are different kinds of descriptive theories in terms of
what they describe or emphasise. A distinction that is commonly made
in accounting in this regard is between economistic theories of
accounting (which typically emphasise financial economistic dimensions)
Chapter 2: Introducing accounting theory
13
and socio-political, or sociological, theories of accounting. The latter
theories are often understood in terms of ‘interdisciplinary perspectives on
accounting’. The logic of this designation is rooted in the view that much
accounting research in business and management schools has been quite
(conventionally) economistic in character, while other disciplines such
as politics and sociology can provide further insights into accounting in
practice.
‘Transdisciplinary’ perspectives in accounting are a related notion.
There is an emphasis here on it being possible to develop and enrich
accounting thought by going beyond the conventional economistic ideas.
The notion that the appreciation and analysis of accounting can benefit
from a variety of disciplinary perspectives is seen in holistic terms in what
might be termed ‘supra-disciplinary’ perspectives on accounting. Here, one
is going beyond the constraints of particular disciplines towards a supra-
disciplinary view (analogous to ‘general systems’ theoretic approaches or
to visions of knowledge in some ancient Greek philosophy that celebrated
a pre-disciplinary holism).
The above points apply equally to management/internal accounting as
well as to external accounting; although the impact on the micro-level
organisation, for instance, tends to be emphasised more in the theorising
of management accounting.
Prescriptive/normative theories of accounting are seen as trying to
develop argumentation about ‘accounting as it should be’– or, maybe, in
a sense more pragmatically, ‘accounting as it could be in terms of a better
accounting’. Again, there is prescriptive/normative theorising of internal/
management accounting as well as of external/financial accounting.
In relation to theories of how things should be (or the modified variant
theories of how things could be better), the question might be asked
‘Who decides on how things should be’? And the answer is in principle,
here, anyone. People will no doubt differ when deciding questions such
as ‘What should accounting be?’, ‘What should the role of accounting
be?’ and ‘How should accounting be regulated?’ Below we consider some
examples of prescriptive theories of accounting that have been given some
emphasis in the accounting literature (and in the context of accounting
policy-making, where clearly prescriptive theorising of accounting is
prominent).
Consistent with the argumentation above, there are different kinds of
prescriptive theorising. Most prescriptive theorising in accounting is of
the financial economistic (we can shorten this to ‘economistic’) type. For
instance, it has been advocated that accounting should improve economic
welfare. Often, related to this, it has been advocated that accounting
should provide information helpful for making good economic decisions.
This is quite a dominant position in the theorising of management
accounting. Related to the notion that accounting provides information
for economic decisions are notions of accounting reporting the position
(value) and income (and/or its assets and liabilities) of an organisation
in economistic terms. Variants of these theories have informed many
instances of accounting policy-making, such as the International
Accounting Standard Board’s (IASB) conceptual framework project.
Economic theorists have written about accounting in these terms.
Note that there are alternative economistic theories that depart from
what have been the common perspectives of policy-makers. For instance,
some have sought that accounting should provide evaluations of business
practices (e.g. how well have managers performed?), some have sought
AC3193 Accounting theory
14
that accounting should give a better indication of the monopolistic
character of business corporations, and some see accounting as giving
insights into how economistic wealth is distributed (e.g. regarding low
wage regimes).
Theorising from more of a socio-political prescriptive position is rarer.
But advocates of corporate social and environmental reporting explicitly
seek that companies produce accounts on their social and environmental
impacts, for instance, and on the diversity of their workforces or boards.
There is the view that accounting in this more holistic sense should
enhance the democratic process through increasing transparency. Some
hold the view that accounting should become more of an instrument
of radical political change. Again, parallels exist between internal and
external accounting in terms of socio-political prescriptive theorising. The
parallels in internal accounting extend here to views such as accounting
practices being more sensitive in relation to creative and innovative
practices, and also being structured so as to enhance workforce well-being.
Terminology
We should note issues with the terminology. All the above terms
– descriptive, positive, prescriptive and normative – have their
faults. The label ‘descriptive’ is potentially confusing as some have
made a distinction between description (or ‘mere description’) and
‘theory’! Perhaps this pejorative usage pertains to the lack of depth
and sophistication in a ‘description’ focused upon, indicating that the
description is pretty basic – perhaps ‘that is just a crudely descriptive
theory’ might be a better expression than ‘that is mere description’ in this
regard as it would be less confusing here.
The word ‘positive’ is also a source of potential confusion here. It
could be confused with ‘positivist’ or ‘positivistic’ (the latter being only
particular types of ‘positive’ theory in our sense). We shall see later
that the word positive is often used where the more particular designation
of positivist or positivistic would be more appropriate – this being
exemplified in the typical and dominant use of the construct ‘positive
accounting theory’, which in substance, beyond the naming, typically
delineates accounting theory that is positivist or substantively positivistic.
Some may not like ‘prescriptive’ because of its possibly negative
connotations regarding prescribed authority (or it may remind some of
prescribed medicine!) – even if the idea may be that people are being
encouraged to think about prescribing themselves rather than being
prescribed to by others.
The concept of ‘normative’ may be considered problematic because of
the root word ‘norm’. A norm may be suggestive of what ‘should be’ in the
absence of critical reflection. But this delimits notions of what should be
from a critical perspective – norms may often be found wanting by those
wanting to go beyond ‘where we are’ to ‘where we should be.’
We might add that notions of what accounting should be and how
accounting should be will always be shaped by the context in which we
are embedded (as is positive/descriptive theorising). So, it is naïve to think
that we can really know what ‘should be’ as far as accounting in society
is concerned. Perhaps it is more appropriate to seek to move towards a
better accounting in a better world.
The above already hints at an appreciation of the situation we are in,
where descriptive theories are not absolutely distinct from prescriptive
theories and vice-versa. A prescriptive theory is bound to be influenced
Chapter 2: Introducing accounting theory
15
by the context in which it emerges and a sense of ‘how things are’. At the
same time, a descriptive theory, most obviously in the social sciences,
cannot be considered absolutely distinct from value positions (see
Winch, 1958; Bernstein, 1976).
If there are theories of ‘how things are’ and theories of ‘how things should
be’ (or ‘how things could be better’), are there theories of ‘how you go
from how things are to how things should be or to a better state in the
more pragmatic variant’? The answer is that there are. And they might be
considered particular forms of prescriptive theorising: how things should
be put into motion so that accounting (and its context) will change in the
desired way – and here accounting itself, or some form thereof, might have
a role in mobilising for change!
Activity 2.1
Look up ‘positive economics’ on the internet.
• In what sense does ‘positive economics’ correspond to a positive (descriptive) theory
as articulated above?
• Search ‘positive accounting theory’ (you will also find positive accounting theory
discussed in Chapter 6 of this subject guide). How is this similar to ‘positive
economics’ and ‘positive/descriptive theory of accounting’?
• In distinguishing between positive and normative theory, what do you think are the
key points?
• Why do some not like the terms ‘positive’ and ‘normative’ in relation to theory?
2.4 Notions of inductive and deductive theorising in
accounting and other categorisations of theorising
There are many ways of categorising ‘positive’ approaches to theory.
2.4.1 Inductive and deductive theorising
Notions of inductive and deductive theorising of accounting reflect
emphases of theory construction. Inductive theorising places emphasis
on building theoretical argumentation about accounting up from the
ground, as it were, as empirical observations are reflected upon to form
and develop theory. Deductive theorising, in contrast, is about deriving a
theory (deducing a theory) from basic theoretical assumptions. A variant
of such an approach to theory construction is found in the hypothetico-
deductive method. In this approach, the theory that is deduced from
the underlying assumptions is sharpened down to a more clearly testable
theory known as a hypothesis. In practice, deductive and inductive
dimensions of theory construction or development are arguably present in
all research and it is the degree to which inductive or deductive processes
matter in a given theory construction that shape whether the theory
constructed might be more appropriately labelled ‘inductive’ or ‘deductive’.
Making the distinction between inductive and deductive theory has a
strong analogy with the distinction Laughlin (1995) makes between open
and closed theory. An open theory is a very loose one that is developed
more substantively in confrontation with empirics as research proceeds.
The emphasis is on being open to the empirics. In practice, this puts a
lot of emphasis on the inductive process of theory construction. A closed
theory is one that is set before the empirical research commences – it is a
case of finding evidence for or against it, rather than developing the theory
through empirics and their interpretation as the research proceeds. This
AC3193 Accounting theory
16
is illustrated substantively by the hypothetico-deductive method as an
approach to theory construction.
2.4.2 More subjectivist and more objectivist accounting theory
In philosophical reflection upon theorising in the social sciences (e.g.
in philosophical reflection upon social and political theory), a common
distinction is made between the ontological and epistemological
nature of the theorising. Ontology is the philosophy of being, concerning
the nature of being and how it is appreciated. Epistemology is the
philosophy of knowledge. It includes consideration of the question:
‘What do we mean when we say we know something?’ When applied
to theorising, this may roughly be translated into: the sense in which
the theory reflects more subjectivist or more objectivist philosophical
orientation (see Bernstein, 1976). Laughlin (1995) appreciates this
explicitly in terms of a continuum or spectrum. More subjectivist theory
gives great weight to researcher interpretations, which may have a
tendency to uniqueness in theoretical character (indicating potential
difficulties in theory appreciation). More objectivist theory sees reality
or being, to express it in ontological terms, as more straightforwardly
present, and knowledge, to put it in epistemological terms, as more in the
nature of concrete facts that can be readily agreed upon.
2.4.3 Critical and conservative theories
One way of classifying theories that has been influential among more
radical sociological and political writers is to position them in terms of
their concern to see the need for radical change in society and to seek to
realise or promote such change. Laughlin (1995), in his three-dimensional
classification scheme, includes a continuum that explicitly refers to
conservative and critical theorising. Willmott (1983) and Chua (1986)
are similarly clear about delineating a category of theory as being more
critical or radical in its orientation. While some writers have collapsed
all ‘critical’ perspectives into a general category beyond the mainstream,
Roslender (2018) suggests that critical accounting theory now tends to be
seen as that theory which gives considerable weight to problematising the
way things are and seeking ways forward that promise betterment (some
express such positioning in the language of progress and emancipation,
albeit typically going beyond the earlier Marxist connotations – see
Gallhofer and Haslam, 2017).
2.4.4 Examples of classification schemes in the accounting
literature
Classification schemes in accounting – and management studies more
generally – have been influenced by some key studies. Bernstein (1976),
Burrell and Morgan (1979, 1981) and Clegg and Dunkerley (1980) would
be included among such key studies.
In the accounting literature, an early study reflecting the influence
is Tomkins and Groves (1983). This study highlights the difference
between more richly interpretive studies of accounting in action and the
more objectivist positive/descriptive studies that have dominated North
American empirical accounting research. Willmott (1983) criticised
the ‘critical’ deficit in Tomkins and Groves; Hopper and Powell (1985)
followed Burrell and Morgan (1979, 1981) very closely; while Chua
(1986) collapses Burrell and Morgan’s (1981) distinction between
more subjectivist and more objectivist radical approaches into a more
general category of radically orientated approaches to accounting theory
Chapter 2: Introducing accounting theory
17
construction – which she contrasts with interpretive and functionalist
approaches (the latter being less radical and more positivistic and realist in
epistemological and ontological terms).
Note that the classification schemes in the above paragraph are within the
positive/descriptive theoretical sphere. Reference in such attempts to the
normative/prescriptive are implicit.
The criteria by which the classification schemes are constructed are
typically presented as continua (most explicitly in Laughlin, 1995).
The schemes are used to position schools of thought in accounting;
these schools of thought may have particular themes, in part beyond
the classification scheme’s criteria – themes that will be discussed later
in this guide in relation to more in-depth consideration of the theories
in accounting, but which may be classified, in part in terms of that
criteria (e.g. in terms of their subjectivism and critical nature). While the
classification schema may be based on continua and distinction in terms of
relative emphasis, in resultant classification schemes, stress is sometimes
placed by advocates of the schemes (following Burrell and Morgan, 1979,
1981) on the mutual exclusivity of the cells created by the intersection of
the continua used to classify. This follows logically from the nature of such
schema (i.e. they are schemes of classification – see Gallhofer et al.,
2013). Classification is an imperfect – and to an extent arbitrary and often
quite crude – process or exercise. It is helpful, however, for the task of
understanding phenomena: in this case, types of accounting theory.
Activity 2.2
From your reading, clarify the meaning of the following terms:
• subjectivism and objectivism in approaches to research
• open and closed theorising and the relationship of these to inductive and deductive
emphases in theory construction
• critical research.
Activity 2.3
Read Laughlin (1995).
• What are the three continua that are the basis for Laughlin’s classification scheme?
• According to Laughlin, why is German ‘critical theory’ a middle-range theory in his
terms?
• What is the relationship between theory, methodology and method?
2.5 Overview of chapter
Theory can be classified in different ways. A key classification is between
positive (descriptive) theory and normative (prescriptive) theory.
Within positive (descriptive) theory there are several possible sub-
classifications. A basic classification in the social sciences and humanities
is the distinguishing of theory in terms of its more subjectivist orientation
or its more objectivist orientation. Some classify theory in terms of its
‘critical’ nature; others distinguish between open and closed theories.
Open theories tend to have an inductive emphasis. Closed theories are
typically deduced from higher theories and may take the form of ‘testable’
hypotheses – they may be understood as having a deductive emphasis.
AC3193 Accounting theory
18
2.6 Reminder of learning outcomes
Having completed this chapter, and the Essential reading and activities,
you should be able to:
• discuss various types of accounting theory.
2.7 Test your knowledge and understanding
1. What are the three cells in Chua’s (1986) classification scheme?
2. What does Chua (1986) effectively do to Burrell and Morgan’s (1981)
two ‘radical’ cells?
3. What does Chua (1986) understand by functionalism?
4. List the positive as well as negative aspects of the theories represented
in the three cells of Chua (in her terms).
5. Do you think there are such things as pure positive theory and pure
normative theory?
6. What is the distinction between inductive and deductive approaches to
theory construction?
7. If a theory is an argument, how can it be backed up or supported?
8. How does Willmott (1983) appraise Tomkins and Groves (1983)?
2.8 Sample examination questions
2.1 Outline the distinction between positive/descriptive and normative/
prescriptive accounting theory. Discuss the view that both types of theory
should be combined in research.
2.2 Outline different types of positive/descriptive accounting theory. What
are the more meaningful categorisations from your perspective?
2.3 Critically evaluate attempts to classify different approaches to
accounting theory construction or critically evaluate an attempt to classify
different approaches to accounting theory construction in the literature.
Chapter 3: Income measurement and capital maintenance
19
Chapter 3: Economist’s interpretation
of income measurement and capital
measurement
3.1 Introduction
This chapter introduces different views of income and capital. One is often
characterised as the view of accountants, the other is often characterised
as the view of economists. The economist’s view is then considered further
in terms of its possible implications for accounting.
3.1.1 Aims of the chapter
The aims of this chapter are to:
• introduce the different views of income and capital
• discuss Hicks’s concept of income
• explain ex ante and ex post.
3.1.2 Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• contrast the accountant’s and the economist’s approach to income and
asset value measurement
• explain Hicks’s definition of ‘well-offness’ and measures of income
numbers 1 and 2
• discuss ex ante income and both ex post incomes for Hicks’s income 1
and 2
• calculate income ex ante and ex post for both Hicks’s income measures
• discuss the implications of Hicks’s income measures for both
economists and accountants.
3.1.3 Essential reading
Alexander, D., A. Britton, A. Jorissen, M. Hoogendoorn and C.V. Mourik
International financial reporting and analysis. (Andover: Cengage Learning
EMEA, 2017) 7th edition [ISBN 9781473725454] Chapter 4.
3.1.4 Further reading
Hicks, J.R. Value and capital. (Oxford: Clarendon, 1946) 2nd edition. Chapter
14.
Hicks, J.R. ‘Incomes’ in Parker, R.H., G.C. Harcourt and G. Whittington (eds)
Readings in the concepts and measurements of income. (Oxford: Philip Allan,
1986) 2nd edition [ISBN 9780860035367].
Lewis, R. and D. Pendrill Advanced financial accounting. (Harlow: Financial
Times Prentice Hall, 2004) 7th edition. [ISBN 9780273658498] Chapter 4.
3.2 A view of income and capital often characterised as
the accountant’s view
The accountant’s view of income measurement here is understood as
computing the income for a period by one or both of two approaches that
logically give the same financial number:
AC3193 Accounting theory
20
1. Take revenues less the cost of sales and other expenses for a period to
compute profit Y
0→1 directly
2. Compute profit for a period by comparing opening and closing net
assets, adjusting for new capital injections or withdrawals, thus
(assuming no capital injections) calculating the value of
NA
1
– NA
0
+ D
0–1
Y
0→1 = NA1 – NA0 + D0–1
Where:
Y
0→1 = profit for the period
NA
1
= net assets at the end of the period
NA
0
= net assets at the beginning of the period
D
0–1
= distribution for the period.
Net profit here is the difference between opening and closing net assets
before distributions: consistent here with seeing the balancing figure in the
balance sheet as profit for the year. By this logic, beyond constraints of a
particular view, income depends on valuation of net assets. The approach
associated with the economist values net assets using net present values
(NPVs).
3.3 A view of income and capital often characterised as
the economist’s view
Economists, however, have a different and more forward-looking view of
income. For instance, economists conceptualise the relationship between
income and capital as:
Y
0→1 = V1 – V0 + D1
Here V
0
is the opening capital value, V
1
is the closing capital value and D
1

represents consumption (or expected cash flow to be received at the end of
year 1). The value of the business is calculated using the present value of
expected cash flows. This chapter will discuss basic economic concepts of
income, followed by a discussion of the difficulties in defining income.
Activity 3.1
Compare and contrast the views of income and capital discussed above.
Activity 3.2
A business is set up by Zillah Corporations with an expected four-year life. At the start of
2010, the cash flows expected to occur at the end of the years to which they relate are:
£
2010 10,000
2011 8,000
2012 6,000
2013 4,000
Assume the interest rate is 10% and is expected to remain constant.
What would be the economic value of the business at the start of 2010 (i.e. V
2010
)?
The solution to this activity is given in Appendix 1.
Chapter 3: Income measurement and capital maintenance
21
3.4 Hicks’s version of the economist’s concept of income
Many accounting theorists have appealed to the notions of Economic
Income developed by Sir John Hicks in his book Value and Capital.1 This
is perhaps strange, as Hicks notes that income is a ‘rough approximation’,
a ‘guide for prudent conduct’, whose purpose in practical affairs is ‘to
give people an indication of the amount which they can consume without
impoverishing themselves’. This leads to Hicks’s central concept of
income:
(Note that Hicks uses ‘week’ to denote a period during which variations
in price might be neglected in analysis; extreme inflatory conditions, for
example, may problematise this.)
Although Hicks’s analysis relates to the individual, it has also been applied
to measuring corporate income. The Sandilands Committee on inflation
accounting based its proposals on Hicks’s central concept, defined for a
company as:
The corporate equivalent of ability to consume is thus related to the
dividend the company could pay.
What, then, does it mean ‘to be as well off’? Hicks spells out a number of
practical ‘approximations’ to his central concept (see below).
3.5 Hicks’s income number 1
Hicks’s first approximation (income number 1) is:
Actually, all Hicks’s constructs refer to the individual’s spending in
a period, if in principle the key to each construct is the individual’s
consumption during the period. Hicks notes that the measure of durable
goods consumption could be difficult without satisfactory secondhand
markets for the goods (if such markets exist, consumption can be
measured by change in the goods’ value over the specified period).
Under Hicks’s number 1, ‘well-offness’ to be maintained is thus the NPV of
future cash flows. Hicks sees this as the definition most people implicitly
use in their private affairs, but as leading to ambiguities when interest
rates change (see Hicks’s number 2 below). Let us assume all future cash
flows occur at the end of each relevant period with certainty, and that
there is one constant interest rate for borrowing and lending. Taking time
0 as the present time and time 1 as the end of the first period (say a year),
we initially use the following notation:
D
1
= the cash flow arising at time 1
V
1
= the capital value at time 1 (= PV of future cash flows from time 1
onwards)
V
0
= the capital value at time 0 (= PV of future cash flows from time 0
onwards).
1 See Further reading
above.
the maximum value a person can consume during a week and
still expect to be as well off at the end of the week as at the
beginning.
the maximum value the company can distribute during the year
and still expect to be as well off at the end of the year as it was
at the beginning.
the maximum amount that can be spent during a period if there
is to be an expectation of maintaining intact the capital value of
prospective receipts (in money terms).
AC3193 Accounting theory
22
The capital values are measured excluding dividends, i.e. V
1
does not
include the cash flow receivable at time 1 (D
1
). Income number 1 for the
period from time 0 to time 1 (Y
0→1) is thus measured as:
Y
0→1 = D1 + V1 – V0
If the individual actually consumes this amount of income (assuming
consumption in the period from t
0
to t
1
is all paid for at the time t
1
), then
remaining wealth at t
1
is V
0
, so the individual is as well-off at the end of
the period as at the beginning. The above expression can be interpreted in
two ways. First, we can write the expression as:
Y
0→1 = (D1 + V1) – V0
The term in parentheses represents the total expected wealth, made up of
net cash received plus the present value of expected future net receipts, at
the end of the first period. So Y
0→1 is the amount by which total wealth is
expected to increase during the period.
The second way of splitting the expression above is:
Y
0→1 = D1 + (V1 – V0)
This can be interpreted as dividing economic income into two components:
the expected cash flow for the period and the expected change in the value
of the individual’s wealth (excluding end-of-period cash D
1
). We might
refer to the component in parentheses as an expected holding gain or
loss. This should be distinguished from a windfall gain or loss (discussed
below), which is unexpected.
Example 1: perpetuity
A government bond pays £150 a year for ever. If the interest rate is 10%,
then the capital value of the bond at time 0 (ex interest) is:
£150 = £1,500 = V0
0.1
At t
1
the value of the bond (cum, or with, interest) is:
£150 = £1,650 = V1
0.1
£150 +
Therefore the income from the bond is:
Y
0→1 = £1,500 – £1,650 = £150
This is the same each year, and the capital value remains at £1,500 (ex
interest).
Example 2: an annuity
An annuity pays £150 p.a. at the end of each of the three years and
costs £373.00. The interest rate is 10%. Analyse each year’s receipts into
‘income’ and repayment of ‘capital’. Assume that all the ‘income’ is spent
and the ‘capital’ receipts are reinvested in a bank account which pays
interest at 10%:
Chapter 3: Income measurement and capital maintenance
23
£ 1 2 3 4 5 6 7 8 9
Opening
value
Income
from
annuity
(10%×1)
‘Capital’
receipt
from
annuity
Total
receipts
from
annuity
Interest
on bank
deposit
@ 10%
(10% × 8)
Total
income
(2+5)
Capital
value of
annuity
after
payment
Bank
balance
Total
capital
(7+8)
Time
t
0
– – – – – – 373.00 – 373.00
t
1
373.00 37.30 112.70 150.00 – 37.30 260.30 112.70 373.00
t
2
260.30 26.03 123.97 150.00 11.27 37.30 136.33 236.67 373.00
t
3
136.33 13.63 136.37 150.00 23.67 37.30 – 373.00 373.00
Thereafter the bank pays £37.30 interest each year on the balance of
£373.00.
Applying the formulae above, we find:
V
0
= £373.00
V
1
= £260.30
D
1
= £150
Y
0→1 = £150 + £260.30 – £373 = £37.30
Note: The actual financing and consumption policy adopted will not alter
the calculation of the income from the annuity in column 1.
Example 3: a ‘capital budgeting project’
An investment project is expected to have the following cash outlays and
receipts.
Time Cash Flows Discount Factor@ 10%
t
0
– 4,000 1.0000
t
1
+2,000 0.9091
t
2
+1,500 0.8264
t
3
+2,000 0.7513
Analyse the cash flows into ‘income’ and ‘capital’, on similar assumptions
to the previous example above and assuming the initial outlay of £4,000
was borrowed via a bank overdraft.
Activity 3.3
If the cost of capital is 10%, what is the NPV of the project to the nearest £1?
The solution to this activity is given in Appendix 1.
AC3193 Accounting theory
24
£ 1 2 3 4 5 6 7 8 9
Opening
value
Income
from
project
(10% × 1)
Capital
receipt or
shortfall
(4 – 1)
Total
project
receipts
(payments)
Interest
received/
(paid) to
bank
(10% × 8)
Total
income
(2+5)
Capital
value of
project
Bank
balance
(overdraft)
Total
capital
(7+8)
Time
t0 – – (4,000) (4,000) – – 4,560 (4,000) 560
t1 4,560 456 1,544 2,000 (400) 56 3,016 (2,456) 560
t2 3,016 302 1,198 1,500 (246) 56 1,818 (1,258) 560
t3 1,818 182 1,818 2,000 (126) 56 – 560 560
Therefore the bank account will pay £56 p.a. interest on the £560 balance.
Applying the valuation and income formulae above:
Project value at time 2 = £2,000 × (0.9091)= £1,818
Example 4: Cash flows
Your friend, Lucas, expects to get cash of £1,000 at time 1 and £2,000 p.a.
thereafter (all cash flows arise at year end) in perpetuity. The rate of interest
is expected to remain at 10% p.a. He wishes to consume all income, but no
more, and can borrow from and lend to the bank at 10% p.a.
What is his income in year 1? Relevant variables are as follows:
D
1
= £1,000
(= cash flow at time 1)
(= PV of future cash flows from t
0
onwards)
= £20,000V
1
=
£2,000
0.1
V
0
=
(= PV of future cash flows from t
1
onwards)
£1,000
1.1
+(
(£2,000
0.1
= £909.09 + £18,181.82 = £19,090.91
1
1.1
×
Therefore income number 1 equals £1909.09:
£1,000 + £20,000 – £19,090.91 = £1,909.09
How can he consume £1,909.09 when the year’s cash flow is only £1,000?
He only has cash of £1,000, but could borrow £909.09 from the bank at the
prevailing rate of interest; this would reduce his capital at time 1 (V
1
) from
£20,000 to £19,090.91 thus maintaining his original capital (V
0
).
Interest of £90.91 p.a. on the loan would reduce net future cash flows to
(£2,000 – £90.91) = £1909.09 p.a. (Rather than borrow, he could realise
£909.09 of the capital value at time 1 by sale, leaving capital value at
£19,090.91, on which future receipts at 10% p.a. would be £1,909.09.)
Future income will remain at £1909.09 p.a. provided he exactly maintains
his opening capital.
In this example income equals the rate of interest (r) applied to the opening
capital value (i.e. rV
0
). This is because V
0
equals (D
1
+ V
1
) discounted back
one period by r, which in turns means that (D
1
+ V
1
) equals (1 + r)V
0
;
income may thus be expressed as (1 + r)V
0
– V
0
, or rV
0
.
It should also be noted that, on the assumptions made so far, if the opening
capital is exactly maintained and all the income (including the accretion to
Project value at time 1 = £1,500 × (0.9091) + £2,000 × (0.8264) = £3,016
Chapter 3: Income measurement and capital maintenance
25
capital value) consumed, then in future years the income figure would be
constant (and equal to rV
0
).
Summary of formulae:
Y
0→1
= D
1
+ V
1
–V
0
V
0 =
D
1
+ V
1
1 + r
(1 + r)V
0
= D
1
+ V
1
Y
0→1 = (1 + r)V0–V0
Y
0→1 = rV0
3.6 Income ex ante and income ex post
If we relax the assumption of certainty, problems arise. In addition
to different people having different expectations about the future, in
conditions of uncertainty actual cash flows will tend to differ from forecast
cash flows. Moreover, new information or changing conditions will revise
expectations about all future cash flows. Given these differences, we will
have different amounts for the capital values at time 1 and time 0, and for
the cash flow at time 1, depending on whether these were calculated at
the beginning or end of the year.
We may call our calculations made at the beginning of the year, at t
0
, ex
ante or ‘forward-looking’ and add the symbol ‘t
0
’ to show they were
computed at time 0 in the light of the knowledge and expectations we had
at that time. We may call our calculations made at the end of the year, at
time 1, ex post, or ‘backward-looking’ and add the symbol ‘t
1
’ to show
they were computed at time 1 in the light of our revised knowledge and
expectations. We use the following notation:
Ex ante variables
D
1
t
0
= the cash flow we expect to receive at time 1, given our
knowledge and expectations at time 0
V
1
t
0
= the expected capital value at time 1, given our knowledge and
expectations at time 0
V
0
t
0
= the opening capital value at time 0, given our knowledge and
expectations at time 0 (This will equal (D
1
t
0
+ V
1
t
0
) discounted back
one period at the rate of interest for that period.)
Ex post variables
D
1
t
1
= the actual cash flow occurring at time 1
V
1
t
1
= the capital value at time 1, given our revised knowledge and
expectations at time 1
V
0
t
1
= the revised calculation of our opening capital value given the
actual cash flow for the year and our revised expectations at the end
of the year. (This will equal (D
1
t
1
+ V
1
t
1
) discounted back one period
at the rate of interest prevailing for that period.)
Given these differences between ex ante and ex post calculations, we now
have different measures of income number 1 depending on the time the
income number is calculated.
3.6.1 Income number 1 ex ante
First of all, we may calculate income ex ante, or ‘forecast’ income based
entirely on our expectations at the beginning of the period, time
0. For Hicks, this is the figure relevant to decisions. This makes sense if
AC3193 Accounting theory
26
income is regarded as a guide to consumption. Income number 1 ex ante
may be expressed as:
Number 1 Y
0→1 ex ante = D1t0 + V1t0 – V0t0
As noted earlier, this equals rV
0
t
0
. For the reason given above, income
number 1 ex ante will always equal interest on the capital value at the start
of the period.
3.6.2 Income number 1 ex post version A and version B
We may alternatively (or in addition) calculate income number 1 ex post,
income for the period calculated at the end of the period. There are,
however, two possible versions of income number 1 ex post, which we will
call ‘version A’ and ‘version B’.
They differ in their treatment of windfall (unexpected) gains and losses.
Windfalls (unexpected) arise from differences between:
• forecast and actual cash flows for the period
• original expectations of future cash flows from the end of the period
onwards and our revised expectations of future cash flows.
(They may also arise from differences between expected and actual
interest rates, or changes in expected interest rates, but we are as yet
assuming constant interest rates.)
Version A
Version A may be expressed as:
Income number 1 Y
0→1 ex post version A = D1t1 + V1t1 – V0t0
This is actual cash flow for the period plus capital accumulated including
windfalls. Hicks describes income ex post as income ex ante plus windfalls.
Thus the definition of ex post income incorporates all windfalls measured
as:
(D
1
t
1
+ V
1
t
1
) – (D
1
t
0
+ V
1
t
0
)
Here, income is no longer equal to rV
0
t
0
(because windfalls are not
reflected in the opening capital value).
It could be argued that the definition of Hicks’s income 1 ex post version
A set out above is meaningless as it compares two numbers calculated
using information available at time t
1
with a number calculated using only
information available at time t
0
. If the individual had the information at t
0

that the individual has at t
1
, the individual’s calculation of NPV would not
have been the originally calculated V
0
t
0
but rather:
V
0
t
1
= (D
1
t
1
+ V
1
t
1
)
1
1+r
This gives an alternative version of ex post income: version B.
Version B
Version B may be expressed as:
Income number 1 Y
0→1ex post version B = D1t1 + V1t1 – V0t1
This is actual cash flow for the period, plus capital accumulation
excluding windfalls.
Windfalls are excluded because we have restated our opening capital with
the benefit of hindsight to what it would have been had we had perfect
foresight at t
0
. This measure would therefore have been our ex ante income
number 1 if we had had perfect knowledge at t
0
; it follows that income
under this version is equal to rV
0
t
1
.
Chapter 3: Income measurement and capital maintenance
27
The treatment adopted for these ex post windfalls determines our ex ante
income for future periods (assuming we consume all income). Including
them in income under version A maintains our originally foreseen capital
value as the basis for measuring future income ex ante and (assuming
constant interest rates) our ex ante income for the next period would equal
ex ante income for this period (rV
0
t
0
). Excluding them from income as per
version B maintains revised opening capital value as the basis for future
ex ante income and (assuming constant interest rates) ex ante income for
the next period would equal ex post (version B) income for this period (=
rV
0
t
1
). Thus this second version of ex post income is closer to Hicks’s own
intentions than version A.
Example 5
A project is expected to generate cash flows of £10,000 p.a. in perpetuity.
The interest rate is expected to remain at 10% p.a. Cash flows arise at year
end. At the end of the first year the actual cash receipts are £5,000. At that
time, expectations of future cash receipts are changed to £12,000 p.a. The
interest rate for the first year is 10% and is expected to remain unchanged.
1. What is the income for the first period (i) ex ante and (ii) ex post?
2. Reconcile the ex ante income with both versions of ex post income.
At time 0 and time 1 we have the following information:
ex ante Beginning of the year
currently here
t0 t1 t2 t3 t
Cash flows 10,000 10,000 10,000 10,000
D1 0 ………….… V 1t0 ………
V 0t0 ………………………………………………………………………
ex post End of the year
currently here
t0 t1 t2 t3 t4
Cash flows 5,000 12,000 12,000 12,000
D1t1 …………. … V 1 1 ……………………
V 0 1t
t
……………………………………………………………………… →

→ 8
4 → 8








D
1
t
0
= £10,000 D1t1 = £5,000
V
1
t
0
=
£10,000
= £100,000
0.1
Ex ante variables
V
0
t
0
=
£10,000
= £100,000
0.1
Ex post variables
V
1
t
1
=
£12,000
= £120,000
0.1
V
0
t
1
=
£5,000
= £113,636
1.1
AC3193 Accounting theory
28
Income 1 ex ante,
Y
0→1
ex ante= D
1
t
0
+ V
1
t
0
– V
0
t
0
= £10,000 + £100,000 – £100,000 = £10,000
(= 10% × £100,000 = rV
0
t
0
)
Income 1 ex post,
Y
0→1
ex post version A = D
1
t
1
+ V
1
t
1
– V
0
t
0
= £5,000 + £120,000 – £100,000
= £25,000
(no longer equal to interest on the opening capital value).
Y
0→1
ex post version B = D
1
t
1
+ V
1
t
1
– V
0
t
1
= £5,000 + £120,000 – £113,636
= £11,364
(= 10% × £113,636 = rV
0
t
1
)
Note that even if ex post income is based upon knowledge of the actual
cash flow that we know at time 1, it is still based upon expectations of the
future from time 1 onwards; V
1
t
1
still measures expected future cash flows
discounted at the expected rate of interest. Thus, income ex post is still a
very subjective measure.
Reconciliation £
1.Budgeted income for year (ex ante)
Revision of current cash flow (D
0
t
1
– D
1
t
0
)
Revision of forecast cash flows
Income for the year (ex post) version A
2.Budgeted income for year (ex ante)
Revision to capital value at beginning of the year due to:
Decrease in actual cash flow
5,000
1.1
=
Revision to forecasts after t
1
: 2,000
0.1

+
Net change
Add interest on net change 13,637 @ 10%
Income for the year (ex post) version B
£10,000
<5,000>
£20,000
£25,000
£10,000
£18,182
£13,637
£1,364
£11,364
×
1
1.1
=
+2,000
0.1
<4.545>
3.7 What if interest rates are expected to change?
So far interest rates have been assumed to remain constant. What happens
if interest rates are expected to change, or change unexpectedly? How
does this affect our concept of income? We have already noted with
income number 1 that unexpected changes in interest rates would give
rise to windfalls through the effect on capital values (see also example
7 below). But Hicks goes further and suggests that once we allow for
changes in the rate of interest we must change our ideas about what
constitutes ‘well-offness’ and hence our ideas about income measurement.
Now that interest rates are allowed to change, the following additional
notation will be used:
Chapter 3: Income measurement and capital maintenance
29
Ex ante variables
r
0
t
0
= the interest rate from time 0 to time 1, given our knowledge and
expectations at time 0
r
1
t
0
= the interest rate from time 1 to time 2, given our knowledge and
expectations at time 0
r
n
t
0
= the interest rate from time n to time n + 1, given our knowledge and
expectations at time 0
Ex post variables
r
0
t
1
= the interest rate that actually prevailed from time 0 to time 1
r
1
t
1
= the interest rate from time 1 to time 2, given our knowledge and
expectations at time 1
r
n
t
1
= the interest rate from time n to time n + 1, given our knowledge and
expectations at time 1
Example 6
A security pays £200 a year forever. At time 0 the interest rate is expected
to be 10% p.a. for the first two years and 20% p.a. thereafter. All cash
flows arise at year end. At the end of each year the difference between
income (calculated on a number 1 basis) and cash received is invested in a
bank account at the prevailing interest rate so as to maintain the opening
capital value. What is income number 1 ex ante for each of the first three
years?
Ex ante variables
D
1
t
0
V
2
t
0
V
1
t
0
V
0
t
0
r
0
t
0
= r
1
t
0
= 10%
r
2
t
0
= 20% = r
n
t
0
for all n from 3 to infinity
= £200 (= D
t
n
0
for all n from 2 to infinity)
=
£200
0.2
= £1,000 (V
n
t
0
for all n from 3 to infinity)
=
£200
1.1
++ ( £2000.2 × 11.1
(
= £1,090.91
=
£200
1.1
++
£200
(1.1)2
++ ( £2000.2 ×
(
= £1,173.55
1
(1.1)2
Y
0→1 = £200 + £1,090.91 – £1,173.55 = £117.36
(=10% × £1,173.55)
£82.64 will be invested in the bank, so that total capital at time 1 is now
£1,173.55 (i.e. the security valued at £1,090.91 plus the bank balance of
£82.64). The expected capital value at time 2 is now the security valued
at £1,000 plus £82.64 in the bank, a total of £1,082.64. The bank pays
interest of £8.27 (rounded) at t2 so that cash receipts at time 2 total
£208.26.
Y
1→2 = £208.27 + £1,082.64 – £1,173.55 = £117.36
£90.91 will be invested in the bank at t2, so that total capital (security plus
bank balance) is once more maintained at £1,173.55; the total amount
now in the bank is £173.55 (i.e. £82.64 plus £90.91), on which interest at
20% will be £34.71 p.a. Future cash receipts will therefore total £234.71.
Capital value at time 3 will consist of the security valued at £1,000 and the
bank deposit of £173.55 = £1,173.55.
Y
2→3 (and each year thereafter) = £234.71 + £1,173.55 –
£1,173.55 = £234.71
AC3193 Accounting theory
30
Since the capital value is henceforth expected to be constant, and the
interest rate to remain constant at 20%, ex ante income for period 3
onwards will be £234.71 p.a. for ever. Thus, according to Hicks’s income
number 1 ex ante, the income stream here will be £117.36, £117.36,
£234.71, £234.71,…,£234.71.
But in these circumstances Hicks suggests that someone who could
consume that pattern of income appears to be getting better off over time
as the prospect of spending £234.71 a year draws nearer; one may be
thought better off if one can consume £234.71 a year rather than £117.36
a year. Yet in his central concept Hicks has defined income as the amount
one can consume during the year while remaining as well-off at the end as
at the start; thus, there would be no change in one’s well-offness.
Hence Hicks suggests that maintenance of the capitalised value of
prospective money receipts does not correspond with our ideas of well-
offness when interest rates change.
3.8 Hicks’s income number 2
The possibility that individuals could exploit changes in interest rates
to change their consumption pattern leads Hicks to develop his second
approximation of income:
For a company we may define it as:
When interest rates are not expected to change (and do not change), this
will be the same as income number 1; if interest rates are expected to
change (or do unexpectedly), the two income measures differ and Hicks
regards number 2 as a better measure of income and closer to his central
concept. In example 6 above, income number 2 would be £200 every year
– the amount the security pays every year regardless of the interest rate.
Note also the effect of an unexpected change in the interest rate on income
number 1, ex post, compared with income 2, even when cash flows are
regular perpetuities.
Example 7
A bond pays £100 at the end of each year forever. The rate of interest is
expected to be 20% p.a. forever (i.e. r
0
t
0
= r
n
t
0
for all n from 1 to infinity),
so the bond’s value is £500 (i.e. 100/0.2). At time 1 the interest rate (r
1
t
1
)
unexpectedly changes to 10% and is expected to remain at 10% forever
thereafter (i.e. r
1
t
1
for all n from 2 to infinity); the bond’s value therefore
rises to £1,000 (i.e. 100/0.1). The revised opening capital value is:
V
0
t
1 =
(D
1
t
1
+ V
1
t
1
)
1.2
= £916.66=
100 + (100/0.1)
1.2
Income ex ante, both number 1 and 2, is £100 (= 20% × £500, i.e.
r
0
t
0
(V
0
t
0
)) since the interest rate is not expected to change.
Income number 1 ex post version A is: 100 + 1,000 – 500 = 600
Income number 1 ex post version B is: 100 + 1,000 – 916.66 = 183.34.
the maximum amount the individual can spend this week and
still expect to be able to spend the same amount in each ensuing
week.
the maximum dividend the company can pay in a period and
still expect to be able to pay the same dividend in all future
periods.
Chapter 3: Income measurement and capital maintenance
31
Although this is 20% on the revised opening capital value (i.e. r
0
t
1
(V
0
t
1
))
note that future income ex ante will no longer be this amount, but
(assuming that all of the income is consumed so that the capital is
maintained at V
0
t
1
) will be 10% × £916.66 = £91.66 (i.e. r
1
t
1
(V
0
t
1
)).
But here income number 2 still measures ex post income as £100. The
constant annual cash flow is unaffected by the change in the interest
rate; it is therefore the amount that can be spent this period with the
expectation of being able to spend the same amount in all future periods.
(As noted below, however, if cash flows are not regular perpetuities, an
unexpected change in the rate of interest will affect income number 2 ex
post.)
Number 2 ex ante
When the net cash flows are regular perpetuities, income number 2 ex
ante will equal the amount of the net cash flows. If they are not regular
perpetuities but interest rates are assumed constant, it will (as noted
above) equal income number 1 ex ante. If the cash flows are not regular
perpetuities and there are expected changes in the interest rate, calculation
of income number 2 ex ante is more difficult. Assuming, however, that just
one change is expected, at time 1, after which rates are expected to remain
constant (i.e. r
1
t
0
= r
n
t
0
for all n from 2 to infinity), then income number 2
ex ante may be calculated by solving for Y in the following:
V
0
t
0
= + ( Yr1t0 × 11 + r0t0
(
1 + r
0
t
0
Y
where Y equals the amount of the annual income. This reflects the fact
that the constant annual stream of consumption when discounted at the
prevailing interest rates must have a present value equal to the opening
‘well-offness’ or capital value. In the case considered here, it may be solved
also by finding income (Y) such that:
Number 2 ex post
Income number 2 will be affected if there are differences between
expected and actual cash flows or differences between originally expected
cash flows and our revised expectations of those cash flows. Once again
we will have ex post measures. Moreover, there will again be two different
measures of ex post income, depending upon how we treat windfalls.
Income number 2 ex post version A may be defined as:
This version treats as windfall gains or losses all end-of-year period wealth
that is not needed to generate in future periods the initially determined
Hicks’s number 2 income ex ante. The second version of ex post Hicks’s
number 2 aims to calculate the amount that, if consumed in the first
period, will leave enough wealth to permit the individual to consume the
same amount in all subsequent periods. Income number 2 ex post version
B may be defined as:
Y =
(1 + r
1
t
0
)
(V
0
t
0
)(r
1
t
0
)(1 + r
0
t
0
)
the maximum amount an individual can consume in a period
and still expect to be able to consume the originally foreseen
number 2 ex ante income in all future periods.
the maximum amount an individual can consume in a period and still
expect to be able to consume the same amount in all future periods.
AC3193 Accounting theory
32
It therefore follows the basic definition of number 2, but calculates as
income what would have been the ex ante income had one, at time 0,
had the knowledge and expectations that one has at time 1. It therefore
excludes windfalls from income.
When the cash flows are not regular perpetuities, an unexpected change
in the interest rate will also affect income number 2 ex post, because of
the additional borrowing and lending necessary to achieve the equalised
stream of consumption.
Example 8
A project is expected to generate cash flows of £2,000 per annum in
perpetuity. The rate of interest is expected to remain constant at 10%.
£2,000 is actually received at time 1, but at that time the rate of interest
suddenly changes to 20% and is expected to remain at that level forever.
Also at that time, expectations of future cash flows are changed to £4,000
per annum forever. All cash flows arise at the end of the year.
What is the income for the first period?
Ex ante Beginning of
the year
currently
here
t0 t1 t2 t3 t
Cash flows2,000 2,000 2,000 2,000
V 0t0 D1t0 ……….… V 1t0 ………
r0t0 = 10%
(= rnt0 for all n from 1 to infinity)
Ex postEnd of the year
currently here
t0 t1 t2 t3 t
Cash flows2,000 4,000 4,000 4,000
V 0t1 D1t1 ……….… V 1t1 ………
r1t1 = 20%
(= rnt1 for all n from 2
to infinity)


→ →
→→
4 → 8
4 → 8
At time 0 and time 1 we have the following information:
Ex ante variablesEx post variables
D
1
t
0
= £2,000 D
1
t
1
= £2,000
V
1
t
0
£2,000
=
0.1
= £20,000
V
0
t
0
£2,000
=
0.1
= £20,000
V
1
t
1
£4,000
=
0.2
= £20,000
V
0
t
1
£2,000
=
1.1
£20,000
+
1.1
= £20,000
Income number 1 ex ante and income number 2 ex ante
These both equal £2,000 per annum since the interest rate was not
expected to change.
Income number 1 ex post
This would also equal £2,000 as capital values at time 1 and time 0 are
unchanged at £20,000.
Chapter 3: Income measurement and capital maintenance
33
Income number 2 ex post version A
Given that there is only one change in the interest rate and it is expected to
be constant from time 1 onwards, income number 2 ex post version A may
be calculated as follows. The original number 2 ex ante income was £2,000.
To maintain it in the future at 20% p.a. requires capital of only £10,000 (i.e.
2,000/0.2). Since the capital value at time 1 (v
1
t
1
) is £20,000, £10,000 of
that may be consumed as income this year, which, added to the actual cash
flow for the period, gives total income for the year of £12,000. This may be
expressed as:
Y = D
1
t
1
+ V
1
t
1

Original number 2 ex ante income
r
1
t
1
To consume this income it would be necessary to sell £10,000 of the
capital value at time 1, or to borrow £10,000 at 20%.
Reconciliation £
Budgeted income for year ex ante
Change in forecasted cash flows+
Change in interest rate
Income for the year ex post version A
+2,000
0.1
2,000
20,000
<10,000>
12,000
=
2,000
0.2
– 2,000
0.1
=
Income number 2 ex post version B
Income number 2 ex post version B may be calculated by making use of the
fact that the revised standard stream of consumption from time 0 onwards
must have a present value, when discounted at the prevailing interest
rates, equal to the revised opening capital value (v
0
t
1
). Thus,
V
0
t
1
= + ( Yr1t1 × 11 + r0t1
(
1 + r
0
t
1
Y
where Y equals the amount of the annual income.
Thus:
2,000 = + ( Y0.2 × 11.1
(
1.1
Y
which, when solved for Y, gives income of £3,666.67. In order to consume
this, capital of £1,666.67 must be realised by sale (or borrowed at 20%),
leaving £18,333.33, on which income at 20% p.a. will be £3,666.67.
More generally, this may alternatively be calculated by solving for Y in the
equation:

Separating Y on the right-hand side gives:
Which eventually resolves to:

AC3193 Accounting theory
34
Reconciliation £
Budgeted income for year ex ante
Change in forecasted cash flows
Interest on revision capital @ 20% (8,333.33 × 0.2) =
Income for the year ex post version B
+2,000
0.2
2,000.00
1,666.67
×
1
1.2
= 8,333.33
3,666.67
Note that this is the only ex post income measure that involves no looking
backwards. The other figures are based on information at time t
0
or use
the interest rate that has just passed. Hicks’s income number 2 ex post
version B uses only end-of-year realisations of cash flows and capital
values and prospective interest rates.
3.9 Hicks’s income number 3
Hicks’s recognises that even income number 2 is not the end of the story,
because if prices are changing we want to be able to consume the same
amount in real terms each week: we need a standard stream of real
consumption. He therefore defines approximation number 3 as:
Hicks sees that the problem with calculating this lies in finding an
appropriate index number of prices – a problem we return to in our
discussions of CPP accounting in Chapter 4.
3.10 Implications of Hicks’s measures of income
Hicks’s price-level income is not uniquely defined. Even ignoring
contrasting changes, and calculation to income numbers 1 and 2, the
result is six different measures of income.
Does this matter?
Hicks observes that all definitions are based on an individual’s
expectations. Income has been defined as a forward-looking, ex ante
concept. This makes sense if income is a guide to consumption. But what
happens if expectations are not achieved? Hicks notes that the value of
an individual’s prospective receipts at the end of the period can be more
or less than the same value determined at the beginning of the period. In
other words, the information available to the individual at the end of the
period may lead to revision of the original calculation of the capital value
of prospective receipts. Basing his discussion on income number 1, Hicks
calls increases or decreases in the capital value of prospective receipts at
the end of the period windfall gains or losses, and describes income ex post
as income ex ante plus windfall gains less windfall losses.
Although Hicks acknowledges that ex post measures of income might have
usefulness as historical measures of activity, he sees no role for them in
economic analysis, as ex post measures (by definition) come too late to
affect individual decision making. This leads him to argue that windfall
gains and losses will come into future income calculations.
Thus Hicks concludes that income is a ‘very dangerous term’, that ‘the
concept is one that a positive theoretical economist only employs in his
argument at his peril’ and that income is ‘a bad tool which breaks in our
hands’.
the maximum amount of money which the individual can spend
this week and still expect to be able to spend the same amount
in real terms in each ensuing week.
Chapter 3: Income measurement and capital maintenance
35
3.11 Implications for accountants
Using income as a basis for sharing out rewards from past performance
(‘ex post settling up’) depends in part on an updated view of likely future
performance.
One version of income ex post (A above) would be objective if the capital
values at the beginning and end of the period were fully represented
by assets whose values were established in perfect markets. The assets
of many manufacturing and trading businesses illustrate that this is
not reality. Such assets are specific and not regularly traded, and the
businesses’ prospects of future earnings depend largely on the skills of
the company’s employees, established trading relationships, reputation
for product quality, market power and so on; in other words the value of
these businesses comprises a large element of ‘goodwill’ whose value is
essentially subjective.
The other version of income ex post (B above) is subjective, relying on
estimates of what the opening capitalised value of the prospects would
have been at the beginning of the period if information available now
had been available then.
From a decision-making perspective, calculation of income ex post has value
primarily in terms of budgetary control (i.e. monitoring of outturn and
revision of plans in order to learn from mistakes in the hope of improving
future decisions). The ex post incomes have little significance on their own
for future decisions – these must be based on the new calculation of income
ex ante for future periods (which version B also provides). As calculation
of the new income ex ante includes the capital value now, this does suggest
that information on the present market values of assets (i.e. current wealth
endowment) may be helpful, to both management and shareholders, in
forming their estimates of a company’s likely future prospects. Although
such estimates must be subjective, it could be helpful for shareholders to be
given the management’s estimates, since these are the basis on which the
management are reinvesting the shareholders’ money.
3.11.1 So what is the value in studying these theoretical concepts
of income?
The value lies not so much in deriving prescriptions for accounting, as
in the appreciation of the following limitations of any practical income
measurement:
1. There can be no objective income measurement (including historical
cost); actual cash flows may be seen as objective financial results. Any
attempt at income measurement requires valuations which in most
cases are subjective and cannot be ‘correct’.
2. Income measurements based on changes in the value of the recorded
‘net assets’ of a business can give only a partial picture of the changes
in the value of the business as a whole.
3. Income measurements ‘ex post’ are not in themselves useful for
management’s or shareholders’ investment decisions. They may help
to improve decision-making (through comparisons with previous
plans), but are only helpful for current and future decisions in so far
as they can assist the formation of expectations about the future. Some
would argue that ex post measures are useful as ‘control’ information
(i.e. providing feedback for assigning responsibility and for corrective
action). But Solomons (1961) argues that two coupled factors also
severely limit the potential of ex post income measurement for control:
AC3193 Accounting theory
36
• the general impossibility of identifying how much of any variance
from, or revision to, a plan is ‘controllable’ and therefore the
responsibility of the relevant manager
• the inherent subjectivity in making revised expectations about the
future.
3.12 Reminder of learning outcomes
Having completed this chapter, and the Essential reading and activities,
you should be able to:
• contrast the accountant’s and the economist’s approach to income and
asset value measurement
• explain Hicks’s definition of ‘well-offness’ and measures of income
numbers 1 and 2
• discuss ex ante income and both ex post incomes for Hicks’s income 1
and 2
• calculate income ex ante and ex post for both Hicks’s income measures
• discuss the implications of Hicks’s income measures for both
economists and accountants.
3.13 Sample examination questions
Honey Plc has a project that is expected to generate cash flows of £8,000
per annum in perpetuity. The interest rate is expected to be 10% in
perpetuity.
Actual cash flows received at Time 1 total £8,000 and the interest rate
changes to 20%. The interest rate is expected to remain at this higher level
in the future.
At Time 1, expectations change and future cash flows per annum are now
expected to double to £16,000.
All cash flows arise at the end of the year.
Required:
Calculate the following for the first period:
i. Hicks’s income number 1 ex ante and income number 2 ex ante.
ii. Hicks’s income number 1 ex post.
iii. Hicks’s income number 2 ex post version A, reconciling your answer to i.
iv. Hicks’s income number 2 ex post version B, reconciling your answer to i.
Chapter 4: Historical cost accounting (HCA) and accounting for changing prices/values
37
Chapter 4: Accounting for changing
prices/values
4.1 Introduction
This chapter extends the discussions on changing prices/values from
AC2091 Financial reporting. We first revisit discussions on the limitations
of historical cost accounting (HCA) and current purchasing power (CPP),
followed by the development of current entry value systems such as
current value accounting (CVA) and replacement cost (RC). We then
consider an approach that tries to combine these two approaches, namely
fully stabilised current value accounting (FSCVA).
4.1.1 Aims of the chapter
The aims of this chapter are to:
• build upon discussions from AC2091
• discuss the limitations of HCA and CPP and other possible approaches
• utilise examples to show how changing prices/values can be accounted
for.
4.1.2 Learning outcomes
By the end of this chapter, and having completed the Essential readings
and activities, you should be able to:
• revisit discussions on the basis of HCA
• describe the advantages and disadvantages of HCA
• identify why other conventions have been proposed as alternatives/
supplements to HCA
• discuss CVA on a replacement cost basis
• explain the concepts of current operating income and holding gains
• discuss different concepts of capital maintenance and their
implications for corporate reporting
• discuss a combined CVA and CPP system (fully stabilised CVA or FSCVA)
• prepare a statement of financial position and income statement using
specific price and/or a combination of specific and general price
indices, including calculating holding gains and losses.
• assess whether deprival values reflect the Hicksian income approach
• delineate advantages and disadvantages of RC accounting and DV
accounting
• prepare a fully stabilised current value income statement and a fully
stabilised balance sheet, including calculating real realised and real
unrealised holding gains/losses
• explain current operating profit and holding gains in fully stabilised
CVA.
4.1.3 Essential reading
Alexander, D., A. Britton, A. Jorissen, M. Hoogendoorn and C.V. Mourik
International financial reporting and analysis. (Andover: Cengage Learning
EMEA, 2017) 7th edition [ISBN 9781473725454] Chapters 5 and 12.
AC3193 Accounting theory
38
4.1.4 Further reading
Baxter, W.T. Inflation Accounting. (Oxford: Philip Allan, 1984) [ISBN
9780860036234] Chapters 3, 8 (pp.103–15) and 12 (pp.182–201).
Ijiri, Y. ‘A defence for historical cost accounting’ in R. Sterling (ed.) Asset
valuation and income determination. (Lawrence, KA: Scholars Book Co.,
1971) [ISBN 9780914348115].
Lewis, R. and D. Pendrill Advanced Financial Accounting. (Harlow: Financial
Times Prentice Hall, 2004) 7th edition [ISBN 9780273658498]. Chapter 4.
Whittington, G. Inflation Accounting: An Introduction to the Debate. (Cambridge:
Cambridge University Press, 1983) [ISBN 9780521270557].
4.2 Introduction to current value accounting (CVA)
In CVA, the balance sheet and income statement show current values in
place of historical cost of assets. One problem is which current values
should be used:
• Replacement cost? (And how should that be defined?)
• Net realisable values?
• Present value (sometimes called ‘economic value’)?
• Deprival value (sometimes referred to as ‘value to the business’ or
‘value to the owner’).
Each valuation method will be investigated.1 We will also explore a
combined CVA/CPP system of accounting and consider two capital
maintenance concepts:
• operating (or physical) capital maintenance
• financial capital maintenance in money terms.
4.3 Worked example and explanation of CVA
4.3.1 Example: Barrow Ltd
Barrow Ltd started business on 1 January 2010. Its summarised balance
sheet at that date was as follows:
£
Non-current assets, at cost 30,000
Inventory, at cost 20,000
Cash 10,000
60,000
10% debentures 10,000
50,000
Ordinary shares of £1 50,000
Other information:
• The non-current assets were purchased on 1 January 2010 and are
expected to have a 10-year life with no residual value.
• On 30 June 2010 inventory which cost £12,000 was sold on credit for
£26,000.
• Expenses of £6,000 were paid evenly throughout the year ended 31
December 2010.
• Debenture interest for the year was paid on 31 December 2010.
• On 31 December 2010, £20,000 was received from trade receivables
and inventory costing £14,000 was purchased on credit.
1 All of these bases of
valuation are further
discussed in Whittington
(1983),pp.115–31.
Chapter 4: Historical cost accounting (HCA) and accounting for changing prices/values
39
The following movements occurred during 2010 in the indices of
replacement cost:
1 January 30 June 31 December
Inventory 100 132 144
Non-current assets 100 110 125
The following are required:
a. An income statement for the year ended 31 December 2010,
and a balance sheet at that date prepared under the historical cost
convention.
b. A current value income statement for the year ended 31
December 2010 and a balance sheet at that date, incorporating
replacement costs for assets sold, consumed and held, on a physical
capital maintenance basis.
c. A current value income statement for the year ended 31
December 2010 and balance sheet at that date, incorporating
replacement costs for assets sold, consumed and held, on a financial
capital maintenance basis.
Note: Base depreciation on the year-end cost of non-current assets for (b)
and (c).
Income statement for (a), (b) and (c)
HC
CVA
Physical
CVA
Financial
£ Index £ £
Sales 26,000 26,000 26,000
Cost of sales 12,000 132/100 15,840 15,840
14,000 10,160 10,160
Depreciation 3,000 125/100 3,750 3,750
Expenses 6,000 6,000 6,000
5,000
Current operating profit 410 410
Debenture interest 1,000 1,000 1,000
(590) (590)
Holding gains:
Non-current assets
– Realised 750
– Unrealised 6,750
Inventories
– Realised 3,840
– Unrealised 3,520
4,000 (590) 14,270
AC3193 Accounting theory
40
Statement of financial position at 31 December for (a), (b) and (c)
HC
CVA
Physical
CVA
Financial
£ Index £ £
Non-current assets
– cost replacement 30,000 125/100 37,500 37,500
– depreciation 3,000 125/100 3,750 3,750
27,000 33,750 33,750
Current assets
Inventory – cost/
replacement cost*
8,000 144/100 11,520 11,520
Inventory – cost/
replacement cost**
14,000 144/144 14,000 14,000
Trade receivables 6,000 6,000 6,000
Cash 23,000 23,000 23,000
51,000 54,520 54,520
Trade payables 14,000 14,000 14,000
Net current assets 37,000 40,520 40,520
64,000 74,270 74,270
10% debentures 10,000 10,000 10,000
54,000 64,270 64,270
Ordinary share capital 50,000 50,000 50,000
Income statement 4,000 (590) 14,270
Capital maintenance
reserve– 14,860–
54,000 64,270 64,270
*The remaining balance of the inventory purchased on 1 January 2010.
**The inventory purchased on 31 December 2010.
Workings and explanation
Unlike CPP, we have only indexed those items for which we have an index
(e.g. inventory and non-current assets). CVA involves multiplying HCA
values by the change in the relevant specific index.
CVA income statement
The change in the relevant index is calculated as follows for the income
statement:
the index on the date of replacement/consumption
the index on the date of transaction
Date of replacement/consumption
• For inventory: cost of sales
The replacement/consumption date is based on the date you actually
sold the inventory. In the above, the sales took place on 30 June. So
the inventory index on 30 June (i.e. 132) is used.
• For non-current assets: depreciation
Chapter 4: Historical cost accounting (HCA) and accounting for changing prices/values
41
The index for depreciation is based on the date of consumption/
replacement. You could assume numerous dates, for example assume
depreciation occurred evenly throughout the year and therefore the
index would be based on the average fixed asset index, say 30 June.
However, for this question you are told that depreciation is based on
the year-end cost and thus the index used is 31 December (i.e. 125).
Transaction date
• For inventory: cost of sales
The date the inventory was purchased – 1 January 2010. Thus the
index is 100.
• For non-current assets: depreciation
The date the non-current assets were purchased – 1 January 2010.
Thus the index is 100.
Calculation of realised holding gains
A realised holding gain is the difference between the current value at the
time of consumption of an asset consumed and its historical cost.
Inventories – cost of sales: realised holding gain
Realised HG = CVA (cost of sales) – HCA (cost of sales)
= £15,840 – £12,000 = £3,840
Non-current assets – depreciation: realised holding gain
Realised HG = CVA (depreciation) – HCA (depreciation)
= £3,750 – £3,000 = £750
CVA balance sheet
The inventory and non-current assets are recorded at their replacement
cost. The calculation of the change in the relevant index is identical to that
used in the CPP accounts:
the index on the date of stabilisation
the index on the date of transaction
Calculation of unrealised holding gains
An unrealised holding gain is the difference between an asset’s current
value at the balance-sheet date and its historical cost (or, if the asset was
owned at the start of the period, its value then).
Inventories – closing inventory: unrealised holding gain
Unrealised HG = CVA (closing inventory) – HCA (closing inventory)
= £25,250 – £22,000 = £3,520
Non-current assets – net book value (NBV): unrealised holding gain
Unrealised HG = CVA (NBV) – HCA (NBV)
= £33,750 – £27,000 = £6,750
Capital maintenance reserve in current value balance sheet
This is simply the total holding gains for the inventory and non-current
assets – realised and unrealised.
AC3193 Accounting theory
42
£
Increased cost of inventory sold 3,840
Increased cost of balance sheet inventory 3,520
Increased depreciation charge 750
Increase in net book value of non-current assets 6,750
14,860
4.4 Combined CPP/CVA system
Lewis and Pendrill (2004, Chapter 21) raise interesting points on: ‘whether
current cost accounting can be further developed as a fully stabilised set of
accounts based on a CPP unit of measurement’; and ask, ‘why not combine
the best features of CVA and CPP?’
As we know, CPP and CVA offer opposing approaches when dealing with
price rises:
• CPP accounting deals with general price rises only.
• CVA deals only with specific price rises.
However, both types of price rise are in fact occurring at the same time.
Consequently, for example, any holding gains on assets under CVA may be
fictitious since, although it may be a money gain, it may not actually be
a real gain.
For example, let us assume you own an asset that had originally cost £15
when purchased a year ago; now the current replacement cost is £20. In
the CVA accounts you would have shown a holding gain of £5. But what
if the RPI had increased over that year by 20%? Thus £3 (20% of £15) of
that holding gain of £5 is not ‘real’ because it cannot be translated into an
increase in purchasing power.
CPP/CVA in combination – known as ‘fully stabilised current value
accounts’ – would indicate whether the company’s financial capital (the
shareholders’ funds) is maintained in real terms. The basic approach
is to restate the CVA accounts into CPP.
Example and explanation
Given the information from the Barrow Ltd example above, the following
movements occurred during 2010 in the retail prices index:
RPI
1 January 2010 100
30 June 2010 110
31 December 2010 121
Required
An income statement for the year ended 31 December 2010 and a balance
sheet at that date, on a financial capital maintenance basis, incorporating
replacement costs for assets sold, consumed and held, stabilised in
purchasing power units of 31 December 2010 (i.e. fully stabilised current
value accounts).
Chapter 4: Historical cost accounting (HCA) and accounting for changing prices/values
43
Income statement for CVA (financial) and fully stabilised CVA (FSCVA)
(financial)
CVA Financial
FSCVA
Financial
£ Index £
Sales 26,000 121/110 28,600
Cost of sales 15,840 121/110 17,424
10,160 11,176
Depreciation 3,750 121/121 3,750
Expenses 6,000 121/120 6,600
Current operating profit 410 826
Debenture interest 1,000 121/121 1,000
(590) (174)
Holding gains:
Non-current assets
– Real realised 750 120
– Real unrealised 6,750 1,080
Inventories
– Real realised 3,840 2,904
– Real unrealised 3,520 1,840
Gains/losses on monetary items
Gain on long-term
monetary items
– 2,100
Loss on short-term
monetary items
– (4,100)
14,270 3,770
Balance sheet at 31 December
CVA Financial
FSCVA
Financial
£ Index £
Non-current assets –
cost/replacement
27,500 121/121 37,500
– depreciation3,750 121/121 3,750
33,750 33,750
Current assets
Inventory – cost/
replacement cost*
11,520 121/121 11,520
Inventory – cost/
replacement cost**
14,000 121/121 14,000
Trade receivables 6,000 * 6,000
Cash 23,000 * 23,000
54,520 54,520
Creditors 14,000 14,000
Net current assets 40,520 40,520
*The remaining balance of the inventory purchased on 1 January 2010.
** The inventory purchased on 31 December 2010.
AC3193 Accounting theory
44
74,270 74,270
10% debentures 10,000 * 10,000
64,270 64,270
Ordinary share capital 50,000 121/100 60,500
Income statement 14,270 3,770
64,270 64,270
Note
* Denotes monetary items.
Definitions
Real realised holding gain. This is the difference between:
1. the current value of an asset at the time of consumption
2. and its historical cost updated to the time of consumption by
movement in the general index.
When necessary, a real gain must then be updated to year-end pounds.
Real unrealised holding gain. This is the difference between:
1. the current value of an asset at the balance sheet date
2. and its historical cost updated by the change in the general index (or,
if the asset was owned at the start of the period, its value then updated
by the change in the general index).
Explanations and notes for guidance
The fully stabilised current value accounts approach is based on the same
concepts and methodology as CPP accounting. However, there are two
issues you need to be aware of:
1. In fully stabilised current value accounts, all transactions are updated
by changes in the general index to express them all in terms of CPP.
However, for the income statement certain items (i.e. cost of sales
and depreciation) have been indexed up to the time of consumption/
replacement. Therefore in order to stabilise these items you need to
index from the date of consumption/replacement, to the date of
stabilisation (in this case 31 December). All other items that are not at
current values (e.g. expenses) need to be represented in CPP and are
based on the CPP methodology.
2. Fully stabilised CVA adjusts the holding gains (real and realised)
by eliminating from profit any appreciation in asset values which is
purely fictitious and measuring only real realised/real unrealised
holding gains and losses (see discussion above). This accords with its
rationale of measuring changes in shareholders’ real capital.
4.4.1 Workings
Inventory – real realised holding gain
The real realised gain equals the amount by which the current value ‘cost
of sales’ at the time of consumption/replacement (i.e. sale) exceeds the
historical cost ‘cost of sales’ adjusted by the changes in the general index
between the times of purchase and the time of consumption/replacement.
Because the gain is here measured at 30 June it must be updated to year-
end £s.
Chapter 4: Historical cost accounting (HCA) and accounting for changing prices/values
45
The HC ‘cost of sales’ (i.e. £12,000) adjusted to time of sale (30 June) by
changes in the general index equals:
£12,000 × 110/100 = £13,200 (CPP @ June £s)
The difference between this and the current value ‘cost of sales’ at 30 June
equals:
This gain updated to year-end £s equals £2,640 × 121/110 = £2,904
(FSCVA @ Dec £s)
Alternatively, you could measure the real realised holding gain on
inventory by deducting:
1. the historical cost ‘cost of sales’ stabilised in year-end £s (as in CPP
accounts) from
2. the fully stabilised current value ‘cost of sales’ (i.e. the current value
‘cost of sales’ stabilised in year-end £s appearing in the fully stabilised
current value accounts).
Using this method, the gain would already be measured in year-end £s.
The historical cost ‘cost of sales’ stabilised in year-end £s equals:
£12,000 × 121/110 = £14,520 (CPP @ Dec £s)
The difference between this and the fully stabilised current value ‘Cost
of Sales’ equals:
£17,424 (FSCVA @ Dec £s) – £14,520 (CPP @ Dec £s) = £2,904
In the calculation of the real realised holding gain above for inventory,
purchases were all made on 1 January (£12,000). The remainder of the
inventory from 1 January (20,000 – 12,000 = 8,000) was transferred
then to the closing inventory, which also saw an additional purchase on
31 December at 14,000, giving a HCA closing inventory total = 8,000
+ 14,000 = 22,000. Therefore, the CPP adjusted cost of sales is simply
the £12,000 inventory purchased on 1 January inflated to 31 December
prices (i.e. 12,000 x 121/100 = £14,520 (CPP @ Dec £s)). If, however,
the cost of sales had different transaction dates for the opening inventory,
purchases and closing inventory respectively, separate CPP index
adjustments need to be applied to the HCA element of each component
making up the cost of sales to work out the overall CPP adjusted cost of
sales.
Inventory – real unrealised holding gain
The real unrealised holding gain equals the amount by which the current
value of the balance sheet inventory (i.e. closing inventory) exceeds its
historical cost adjusted by the increase in the general index from time of
purchase to the balance sheet date.
The historical cost ‘closing inventory’ stabilised in year-end £s equals:
Transaction HCA CPP
1 January £8,000 × 121/100 = £9,680
31 December£14,000 × 121/121 = £14,000
£23,680
Hence the real unrealised holding gain on inventory equals:
£25,520 (CVA @ Dec £s) – £23,680 (CPP @ Dec £s) = £1,840
£15,840 (CVA @ 30 June £s) – £13,200 (CPP @ 30 June £s) = £2,640
AC3193 Accounting theory
46
Non-current assets – real realised holding gain
The real realised holding gain be calculated as the difference between:
1. the current value depreciation charge and
2. the historical cost depreciation charge adjusted by the change in the
general index from the time of purchase to the time of consumption.
As this is here taken as the year-end, no further stabilisation is required.
Depreciation (£HCA) = £3,000
Therefore:
Depreciation (£CPP) = £3,000 × 121/100 = £3,630
Thus the real realised holding gain is:
£3,750 (FSCVA @ Dec £s) – £3,630 (CPP @ Dec £s) = £120
Non-current assets – real unrealised holding gain
The real unrealised holding gain may be calculated as the difference
between:
1. the current value net book value at the balance sheet date and
2. the historical cost net book value adjusted by the change in the general
index from time of purchase to the balance sheet date.
Thus:
£HCA £CPP
Non-current assets – net book value = 27,000 × 121/100 = £32,670
Therefore the real unrealised holding gain on non-current assets equals:
£33,750 (FSCVA @ Dec £s) – £32,670 (CPP @ Dec £s) = £1,080
An alternative: calculating total real holding gains
Total real holding gains (i.e. realised and unrealised) can be calculated
as they equal the amount by which the gross current value at the balance
sheet date is less than the historical cost adjusted by the change in the
general index from purchase date to balance sheet date.
£HCA £CPP £CVA
Non-current assets @ cost 30,000 × 121/100 = 36,300 37,500
Therefore:
£37,500 (FSCVA @ Dec £s) – £36,300 (CPP @ Dec £s) = £1,200
Of that, 1/10th has been realised by use (i.e. expected life = 10 years of
which one had expired), resulting in a real realised holding gain of:
1/10 × 1,200 = £120
and a real unrealised holding gain (i.e. 9/10 is unrealised) of:
9/10 × 1,200 = £1,080.
Activity 4.1
Show that:
a. the gain on long-term monetary items in the income statement above equals £2,100
b. the loss on short-term monetary items in the income statement above equals £4,100.
If you have problems with this activity, refer back to the discussion on CPP accounting.
Chapter 4: Historical cost accounting (HCA) and accounting for changing prices/values
47
4.5 Reminder of learning outcomes
Having completed this chapter, and the Essential reading and activities,
you should be able to:
• revisit discussions on the basis of HCA
• describe the advantages and disadvantages of HCA
• identify why other conventions have been proposed as alternatives/
supplements to HCA
• discuss CVA on a replacement cost basis
• explain the concepts of current operating income and holding gains
• discuss different concepts of capital maintenance and their
implications for corporate reporting
• discuss a combined CVA and CPP system (fully stabilised CVA or
FSCVA)
• prepare a statement of financial position and income statement using
specific price and/or a combination of specific and general price
indices, including calculating holding gains and losses.
4.6 Sample examination question
Boris Ltd started trading on 1 January 2014. The income statement for the
year ended 31 December 2014 and the statement of financial position as
at that date are as follows:
Income statement for the year ended 31 December 2014
£ £
Sales revenue 4,050,000
Less: Cost of sales
Opening inventories 225,000
Purchases 2,700,000
Closing inventories (270,000)
2,655,000
Gross profit 1,395,000
Expenses 450,000
Depreciation 126,000
Net profit 819,000
Statement of financial position as at 31 December 2014
£
Non-current assets
Property, plant & equipment (PPE) 3,888,000
Inventories 270,000
AC3193 Accounting theory
48
Other net current assets 1,161,000
Net Assets 5,319,000
Share capital (£1 shares) 4,500,000
Retained profits 819,000
Equity 5,319,000
The price change indices for the year are identified as follows (RPI = retail price
index):
RPI PPE Inventories
1 January 2014 200 200 250
30 June 2014 220 240 270
30 November 2014 230 260 280
31 December 2014 240 300 290
Closing inventory was acquired on 30 November 2014. All non-current
assets and opening inventory were acquired on the first day of trading.
Sales and purchases accrue evenly throughout the year.
Required
(a) Define fully stabilised current value accounts and discuss their
advantages and limitations.
(b) Prepare an income statement for Boris Ltd for the year ended 31
December 2014 and a statement of financial position as at 31 December
2014 using current value (replacement cost) accounting and using the
financial capital maintenance concept. Base depreciation on the year-end
value of non-current assets.
(c) Calculate the real realised and the real unrealised holding gains and
losses on inventory and non-current assets that would appear in a set of
fully stabilised current value accounts, stabilised in pounds (£) as at 31
December 2014. Where should these items be recorded on the financial
statements for 2014?
Chapter 5: Deprival value
49
Chapter 5: Deprival value
5.1 Introduction
There have been many attempts to identify an alternative accounting
system to historical cost accounting (HCA). Deprival value is a good
way of thinking about how to value an asset, combining an assortment
of measurement systems to represent a decision-oriented measurement
system to capture the ‘value to the business’ or ‘value to the owner’. This
chapter discusses deprival values as a mixed value accounting system to
deal with changing prices/values.
5.1.2 Aims of the course
The aim of this chapter is to:
• introduce the concept of deprival value.
5.1.3 Learning outcomes
By the end of this chapter, and having completed the Essential readings
and activities, you should be able to:
• explain the concept of deprival value (DV)
• discuss replacement cost (RC), net realisable value (NRV) and present
value (PV)
• calculate deprival values when replacement involves:
• a brand new asset
• prices changing
• technological changes
• assess whether deprival values reflect the Hicksian income approach
• delineate advantages and disadvantages of RC accounting and DV
accounting.
5.1.4 Essential reading
Alexander, D., A. Britton, A. Jorissen, M. Hoogendoorn and C.V. Mourik
International financial reporting and analysis. (Andover: Cengage Learning
EMEA, 2017) 7th edition [ISBN 9781473725454] Chapter 6.
5.1.5 Further reading
Lewis, R. and D. Pendrill Advanced financial accounting. (Harlow:
Financial Times Prentice-Hall, 2004) 7th edition [ISBN 9780273658498].
Chapter 4.
5.2 Deprival value
Deprival value was developed from the ideas of Bonbright who wrote
(in The Valuation of Property, 1937):
In other words, the DV of an asset is the amount of the loss which a
business would suffer if that asset was lost or destroyed, assuming that the
The valuation of a property to its owners is identical in amount
with the adverse value of the entire loss, direct and indirect,
that the owner might expect to suffer if he were to be deprived
of the property.
AC3193 Accounting theory
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owner takes optimal action on deprival. According to the circumstances,
deprival value will either be RC or NRV or PV (typically, in use).
DV = min.[RC, max (NRV,PV)]
Or diagrammatically:
Deprival value = lower of:
RC
higher of:
NRV PV
If the asset is traded in a good market RC and NRV will be available.
Alexander et al. (2005, p.95) discuss the six possible relationships that
exist between these three values, which can be summarised as follows:
Correct valuation
NRV > PV > RC RC
NRV > RC > PV RC
PV > RC > NRV RC
PV > NRV > RC RC
RC > PV > NRV PV
RC > NRV > PV NRV.
The relationships can be described as follows:
1. If an asset is worth replacing then state it at RC.
2. If an asset is not worth replacing but is worth keeping then state it at
PV in use.
3. If an asset is not worth replacing or keeping then state it at NRV (or,
conceivably, PV from sale if that differs from NRV).
DV reflects courses of action implied by mainstream economics and values
assets on this basis. It asks how much compensation would be needed if
the asset was lost. Problems in calculating the DV of depreciating assets,
and pros and cons of DV are considered later.
Example: DV
CheapAir Ltd., a small airline company, has decided to account for
assets on a current value basis, using DV as current value. However,
the accountant does not understand DV and has asked you to help. The
table and notes below give management estimates relating to two of the
company’s aircraft, the 001Y and the 890T.
Activity 5.1
Let us assume you were going to attend an interview for a job paying £20,000 p.a. and
an hour before the interview someone spilt coffee down your business suit. The cost of
replacing your suit would be £800 and you don’t have time to get it cleaned before the
interview. What would be the best action to take and hence what would be the deprival
value of your suit?
The solution to this activity is given in Appendix 1.
Chapter 5: Deprival value
51
001Y 890T
£ £
Net book value 50,000 1,400,000
Net realisable value in market 60,000 1,400,000
Current purchase price of an aircraft
in similar condition 90,000 1,500,000
Notes:
a. 001Y is rarely used, but is kept as a stand-by machine. If it were not
available it is estimated that average annual cash outlay on rental of
£17,000 would have to be spent on hire of a machine from another
company. The annual expenditure on keeping 001Y airworthy is
£10,000. Stand-by facilities will continue to be required as long as can
be foreseen.
b. 890T if retained would have in its best use an expected flying life
of 10 years with the company, at the end of which its NRV would be
£600,000. Its annual net contribution to the cash flow over the ten
years would be £240,000.
The company expects to earn 10% p.a. on capital invested. This discount
rate should be used in your calculation.
To ascertain the DVs you will need the PV, the NRV and the RC for each
aircraft. You currently, in the table above, have the RC and NRV; therefore
you need to calculate their PVs (in use).
Calculating the PV for 001Y and 890T
001Y:
The net annual saving of cash expenditure on stand-by:
£
Rent saved 17,000
Less maintenance required on present machine (10,000)
7,000
Present value of perpetuity at 10% p.a. therefore equals £70,000
890T:
Cash flow PV
Annual contribution in service 240,000
(i) Present value of 10-year annuity at 10% 1,474,800
Terminal realisation value 600,000
(ii) Present value of terminal realisation value 231,600
Present value of future contribution in use ((i)+(ii)) 1,706,400
Calculating deprival value for 001Y and 890T
001Y
For aircraft 001Y, RC= £90,000, NRV = £60,000 and PV (in use) =
£70,000. Under these conditions it is worthwhile for the company to
retain the asset since it is worth more in use than selling now, that is,
PV (in use) >NRV. Given that PV (in use)NRV. However, unlike aircraft 001Y, RC RC of total business.
– The sum of RC of individual assets > PV (in use) of total business.
– The sum of PV of individual assets > PV (in use) of total business.
• Does the concept of deprival have meaning for all assets (e.g.
development expenditure)?
• Is the idea of replacement always appropriate (e.g. development
expenditure, goodwill)?
Note: Many of these problems would apply equally to other systems; for
example, one based purely on PV (in use) would be subjective, while those
based purely on RC would have the same problems about the absence of
good markets, and piecemeal versus wholesale replacement.
5.5 Reminder of learning outcomes
By the end of this chapter, and having completed the Essential readings
and activities, you should be able to:
• explain the concept of deprival value (DV)
• discuss replacement cost (RC), net realisable value (NRV) and present
value (PV)
• calculate deprival values when replacement involves:
• a brand new asset
• prices changing
• technological changes
• assess whether deprival values reflect the Hicksian income approach
• delineate advantages and disadvantages of RC accounting and DV
accounting.
AC3193 Accounting theory
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5.6 Sample examination question
Easi-copter is a helicopter company, which is considering using deprival
value for valuing its assets. The company provides you with the following
Information on two of its helicopters – the ‘basic’ and the ‘super’.
‘basic’ ‘super’
Net book value 25,000 700,000
Net realisable value in market 30,000 720,000
Current purchase price of a
helicopter in similar condition
45,000 750,000
The ‘basic’ is kept as a standby machine i.e. will only be used if there is
a problem with the ‘super’. If the company did not have this machine, it
is estimated that average annual cash outlay on rental of £8,500 would
have to be spent on hiring another machine. The annual expenditure on
keeping the ‘basic’ maintained properly is £5,000. The standby facility will
be required for the foreseeable future.
The ‘super’ has a flying life of 10 years, at the end of which its net
realisable value would be £300,000. Its net annual contribution to the
cash flow over the ten years is expected to be £120,000.
Easi-copter expects to earn 10% on capital invested.
Required
a. Define, and critically assess, deprival value.
b. Calculate the deprival value for both the ‘basic’ and the ‘super’, giving
explanations of why this is so.
Chapter 6: Positive/descriptive economistic theory of accounting
59
Chapter 6: Positive/descriptive
economistic theory of accounting
6.1 Introduction
This chapter aims to place the emergence of a particular approach
to accounting theory development – the dominant form of positive/
descriptive economistic accounting theory – in historical context. At
the core of the chapter, the concern is to elaborate, in terms of its key
characteristics, the type of theory generated by this approach – labelled
here positive/descriptive economistic accounting theory. We will then
go on to outline research that has contributed to accounting theory
development of this kind and offer a critique.
6.1.1 Aims of the chapter
The aims of this chapter are to:
• provide an historical context for positive/descriptive economistic
accounting theory
• examine positive/descriptive economistic accounting theory in more
detail.
6.1.2 Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• trace the emergence of positive/descriptive economistic accounting
theory
• elaborate key characteristics of positive/descriptive economistic
accounting theory
• discuss studies that have helped to contribute to positive/descriptive
economistic accounting theory, including in relation to efficient
markets research
• evaluate positive/descriptive economistic accounting theory.
6.1.3 Essential reading
Whittington, G. ‘Financial accounting theory: an overview’, British Accounting
Review 18(2) 1986, pp.4–41.
6.1.4 Further reading
Ball, R. and P. Brown ‘An empirical evaluation of accounting income numbers’,
Journal of Accounting Research 6(2) 1968, pp.159–78.
Watts, R.L. and J. Zimmerman Positive accounting theory. (Englewood Cliffs,
NJ: Prentice-Hall, 1986) [ISBN 9780136861713].
6.1.5 References cited
Barth, M.E., Y. Konchitchki and W.R. Landsman ‘Cost of capital and earnings
transparency’, Journal of Accounting and Economics 55(2–3) 2013, pp.206–
24.
Becker, C.L., M.L. Defond, J. Jiambalvo and K. Subramanyam ‘The effect of
audit quality on earnings management’, Contemporary Accounting Research
15(1) 1998, pp.1–24.
Botosan, C.A. ‘Disclosure level and the cost of equity capital’, The Accounting
Review 72(3) 1997, pp.323–49.
AC3193 Accounting theory
60
Clarkson, P., D. Joyce and I. Tutticci ‘Market reaction to takeover rumour in
internet discussion sites’, Accounting and Finance 46(1) 2006, pp.31–52.
Cotter, J. and I. Zimmer ‘Why do some firms recognize whereas others only
disclose asset revaluations?’ 1999. dx.doi.org/10.2139/ssrn.191448
Dechow, P.M., R.G. Sloan, and A.P. Sweeney ‘Detecting earnings management’,
The Accounting Review 70(2) 1995, pp.193–225.
DeFond, M.L. and J. Jiambalvo ‘Debt covenant violation and manipulation of
accruals’, Journal of Accounting and Economics 17(1–2) 1994, pp.145–76.
Degeorge, F., J. Patel and R. Zeckhauser ‘Earnings management to exceed
thresholds’, Journal of Business 72(1) 1999, pp.1–33.
Francis, J., R. LaFond, P.M. Olsson and K. Schipper ‘Cost of equity and earnings
attributes’, The Accounting Review 79(4) 2004, pp.967–1010.
Jones, J.J. ‘Earnings management during import relief investigations’, Journal
of Accounting Research 29(2) 1991, pp.193–228.
Kothari, S.P. ‘Capital markets research in accounting’, Journal of Accounting and
Economics 31(1–3) 2001, pp.105–231.
Lang, M.H. and R.J. Lundholm ‘Corporate disclosure policy and analyst
behavior’, The Accounting Review 71(4) 1996, pp.467–92.
Lee, C. ‘Market efficiency and accounting research: a discussion of “Capital
markets research in accounting” by S.P. Kothari’, Journal of Accounting and
Economics 31(1–3) 2001, pp.233–53.
Leuz, C., D. Nanda and P.D. Wysocki ‘Earnings management and investor
protection: an international comparison’, Journal of Financial Economics
69(3) 2003, pp.505–27.
Lev, B. ‘On the usefulness of earnings: lessons and directions from two decades
of empirical research’, Journal of Accounting Research 27(Supplement)
1989, pp.153–92.
Lewellen, W., C. Loderer and K. Martin ‘Executive compensation and executive
incentive problems: an empirical analysis’, Journal of Accounting and
Economics 9(3) 1987, pp.287–310.
Lundholm, R. and L.A. Myers ‘Bringing the future forward: the effect of
disclosure on the returns-earnings relation’, Journal of Accounting Research
40(3) 2002, pp.809–39.
Mather, P. and G. Peirson ‘Financial covenants in the markets for public and
private debt’, Accounting and Finance 46(2) 2006, pp.285–307.
Nagar, V., D. Nanda and P. Wysocki ‘Discretionary disclosure and stock-based
incentives’, Journal of Accounting and Economics 34(1–3) 2003, pp.283–
309.
Ness, K.E. and A.M. Mirza ‘Corporate social disclosure: a note on a test of
agency theory’, British Accounting Review 23(3) 1991, pp.211–17.
Peasnell, K.V., P.F. Pope and S. Young ‘Accruals management to meet earnings
targets: UK evidence pre- and post-Cadbury’, British Accounting Review
32(4) 1991, pp.415–55.
Sloan, R.G. ‘Do stock prices fully reflect information in accruals and cash flows
about future earnings?’, The Accounting Review 71(3) 1996, pp.289–315.
Stein, J.C. ‘Efficient capital markets, inefficient firms: a model of myopic
corporate behavior’, Quarterly Journal of Economics 104(4) 1989, pp.655–
69.
Sutton, T.G. ‘The proposed introduction of current cost accounting in the UK’,
Journal of Accounting and Economics 10(2) 1988, pp.127–49.
Zhang, J. ‘The contracting benefits of accounting conservatism to lenders and
borrowers’, Journal of Accounting and Economics 45(1) 2008, pp.27–54.
6.2 Historical context
The growth in higher education in the latter half of the 21st century
in many countries throughout the world brought enhanced academic
attention to accounting. The formation and expansion of management
Chapter 6: Positive/descriptive economistic theory of accounting
61
and business schools entailed increased academic focus on accounting,
which reflects that it is a discipline of management (or governance)
at organisational and social levels. Further, the professional status of
accounting (i.e. accounting’s position as a key practice of the accountancy
profession) also effectively added to the growth of accounting academia,
in part through the professional accreditation of degree programmes. This
new direction encouraged innovation.
At the point when this expansion occurred, two approaches dominated
accounting research. One was prescriptive and financial economistic,
tending to articulate accounting’s role in facilitating sound economic
decisions, including, in the sphere of external accounting, for instance,
better representing income and capital (see earlier chapters). The other
was descriptive and aimed to understand the current financial accounting
prescriptions (then often recommendations, with standards increasingly
appearing from the 1970s) and in effect to codify them. Innovation
came partly and significantly with the rise of a descriptive (‘positive’)
economistic approach to accounting theory development.
Activity 6.1
• Do you think ‘positive’ and ‘normative’ encompass the entirety of possible theories?
• Do you think ‘positive’ and ‘normative’ are appropriate words to use here as
classificatory labels?
6.3 The character of positive/descriptive economistic
accounting theory
The focus is upon financial economistic and related informational
dimensions of accounting.
Aligned to the notion of ‘positive economics’, the ostensible concern is to
develop theories of accounting in practice and uncover accounting’s
impact in practice. Questions asked have included whether financial
accounting information impacts upon stock market prices.
A preference for the prevailing research methods of the discipline of
economics is evident; the usage of large samples of quantitative data and
the promotion of statistical and econometric analysis have dominated
research of this kind. This is a promotion of the ‘scientific method’ that
is associated with the natural sciences within the social sciences.
6.4 Theories linking accounting with the notion of
efficient markets
Corporate accounting information is often in many jurisdictions a key
form of publicly available information about companies. Consequently,
accounting has been integral to much research on the efficient markets
hypothesis.
The efficient markets hypothesis is actually an hypothesis about
information. It is often tested in three different forms (which already
suggests potential interpretation problems). In generic terms, it states that
new information is very rapidly reflected in markets and in an unbiased
manner (consistent with rational pricing as per a rational pricing model).
An implication of the hypothesis concerns the profitability of trading
on the information. Given the very rapid price reaction it is difficult for
anyone to consistently make abnormal profits.
AC3193 Accounting theory
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As indicated above, the hypothesis is manifest in three different forms.
The ‘strong’ form states that all new information (publicly available and
privately held) is efficiently reflected in prices in an unbiased measure.
The ‘semi-strong’ form states that all new publicly available information
is efficiently reflected in prices and in an unbiased manner. And the ‘weak
form’ states that it is not possible to consistently make abnormal profits by
trading on the information that is in past prices (the movements thereof)
and past movements in trading volumes.
Results of research are difficult to interpret partly due to issues of method.
Many of the weak form tests and semi-strong form tests have found
evidence in favour of the hypothesis (Watts and Zimmerman, 1986). Sloan
(1996) found share prices to act (against the efficient markets notion)
as if investors were fixated on reported earnings without considering
the relative magnitudes of cash and accrual components. Clarkson et al.
(2006) found that takeover rumours were quickly priced in the market but
that reactions could be different from rational pricing, reflecting ‘pump
and dump’ strategies, for example. But the results in general should be
treated with caution. We can point, especially so in earlier studies, to
weaknesses in terms of the actual statistical methods used, including
issues of sample size. Tests reliant on findings in terms of making
abnormal profits suffer from issues of transaction cost estimation. The
possible trading strategies can never be exhausted in weak form tests, so
the point that the key strategies are not tested can always be made. The
authors are aware of one technical analyst who worked for many years
for a big city firm in London and claimed to consistently make abnormal
profits by following a complex mathematical trading strategy based on
movements in past prices and trading volumes. But, if he kept his job for
many years, he never disclosed his mode of analysis. Studies concluding in
favour of the efficient markets hypothesis often do so with an unwarranted
rhetorical flourish, while papers finding to the contrary often refer to
finding ‘anomalies’. Strong form tests are, unsurprisingly, especially
difficult to conduct and results here are even less reliable.
In terms of policy implications, what do results of efficient markets
research in this area imply, even if we were to (naively) assume that
the results are reliable? Positive weak form test results do not tell us a
great deal, which is not to suggest that they tell us nothing. It would be
disappointing and somewhat surprising if traders could (except by outside
chance) consistently make abnormal profits by trading on movements
in past prices and trading volumes. Positive semi-strong form results in
relation to publicly available accounting information indicate that more
and better-quality accounting information may improve market pricing
very speedily; although this may in itself not be the same as improving
social well-being – it might even negatively impact other forms of
economic efficiency. It is worth emphasising this because some might
conclude differently, influenced by some of the rhetoric in this area to
hold, incorrectly, that a positive result in semi-strong testing points to
accounting’s irrelevance (more on this later). Positive results from strong
form tests would indicate that existing regulations are working well as
far as informational efficiency is concerned (we should note here again
that informational efficiency is not the same as other types of economic
efficiency). If the goal is informational efficiency, more regulation is
unnecessary – although the idea that rolling back regulation as advocated
in neoliberal policy is not implied by the finding of even strong form
efficiency, let alone other forms (in practice, a dubious rhetoric may
suggest otherwise).
Chapter 6: Positive/descriptive economistic theory of accounting
63
Many other positive accounting theories are developed on the
assumption that markets are efficient at least in the semi-strong sense.
The semi-strong hypothesis, to the extent that it has some validation, may
be seen as an accounting theory suggesting accounting’s rapid impact on
stock markets. Further, the policy implications set out above may be seen
as accounting theories (or theories implicating accounting) based on or
shaped by the positive research focused upon.
Activity 6.2
• Summarise the meaning of ‘efficient markets research’.
• What are the policy implications of its findings?
6.5 Other studies
Some studies, assuming an efficient market at least in a semi-strong
sense, have sought to investigate whether accounting numbers, given this
assumption, are impounded into share prices. Early studies suggested
that accounting numbers were in this sense used by the market but were
not so important. Ball and Brown (1968) investigated the reaction of stock
market prices to earnings announcements and found that these accounting
announcements were useful to the marketplace and had information
content. At the same time, 85–90% of earnings announcements were
anticipated by the market, so much information is obtained from other
sources. Policy implications here are not so easy to decide upon. Leaving
aside issues with the methods (and the assumption about market
efficiency), even if 100% of the announcements were anticipated, the
character and quality of that anticipation may be influenced by dimensions
of the accounting process, while the effect of an accounting visibility
may become more apparent and accessible later (and an accounting may
affect intra-individual utility transfers, as manifested in trading). Further,
earnings are only one component of accounting information. And better
quality accounting numbers including more disclosure could still be better
in terms of stock market pricing. Especially if we relax the assumption
of market efficiency, a very strong point becomes that which would
question whether evidence of usage is evidence of usefulness from a
social welfare perspective. We should also note that (as some studies have
indicated) the information content of accounting numbers varies between
institutional contexts. For instance, in countries with smaller companies
in relative terms, share prices can incorporate information from a more
limited range of sources.
Lev (1989) raises an interesting issue about the results of research on
the information content of accounting earnings numbers. The particular
relation of earnings and stock market prices is some distance from what
may be reasonably expected. Does it suggest that the market responds
inappropriately to earnings information (raising issues about market
efficiency)? As we note below, Watts and Zimmerman (1986) suggest that
investors are scarcely fooled by changes in accounting methods (they are
only a little functionally fixated on the earlier method as seen in Kothari,
2001). There does seem to be a tendency to underreact to earnings news
(see, again, Kothari, 2001), and the point above concerning the quality
and content of accounting information may be relevant (Lee, 2001).
There is also the possibility that earnings management or the gap between
reported and ‘permanent’ earnings may be a factor (empirical results are
difficult to interpret). There is also some work to suggest that reported
earnings lack timeliness (see Lundholm and Myers, 2002).
AC3193 Accounting theory
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One study looking at the reaction of the stock market to accounting
information found that investors placed greater reliance on recognised
amounts rather than on disclosed amounts (Cotter and Zimmer, 1999) – it
should be pointed out here that the Enron corporation, which was guilty
of very dubious accounting practice, disclosed some key liabilities in a note
rather than in the main accounts or financial statements.
It has been found that firms with policies to disclose more have a larger
analyst and investor following, reduced information asymmetry and more
accurate analyst earnings forecasts (Lang and Lundholm, 1996). They also
have reduced costs of equity capital (Botosan, 1997). More generally, firms
with better accounting quality measured in a number of ways tend to have
reduced costs of financing (Francis et al., 2004; Barth et al., 2013).
In terms of studies exploring factors enhancing accounting quality, Becker
et al. (1996) explore the effect of audit quality (suggesting it is positive),
while Peasnell et al. (2000) explore the impact of corporate governance
(suggesting that board independence makes a positive impact, for
example). Leuz et al. (2003) in a cross-country study find that earnings
management tends to reduce with increased institutional levels of investor
protection.
There are a number of generic reasons why firms may wish to engage in
earnings management practices (which may be directed at balance
sheet residuals as well as or instead of the income statement). Not all
of these are synonymous with ‘bad’ accounting. Earnings management
practices may signal to the market the current and future performance
of the firm. There may also be a concern on the part of corporate
management to account in a way that minimises costs linked to structuring
business relationships (the efficient contracting view). A more prominent
explanation – which is linked to the notion of improper accounting
practice – can be summarised in terms of management opportunism
in principal-agency terms, whereby managers seek to transfer wealth
to themselves from the shareholders (and more generally in terms of a
concern on the part of the managers to transfer wealth to themselves from
all the other stakeholders).
Studies suggest that various types of earnings management (consistent
with management opportunism) are practiced quite regularly, most
clearly in North America (the focus of much of the research). Watts and
Zimmerman (1986) point to several studies that suggest investors are
not fooled by such accounting manipulation – but it is again a difficult
thing to test and an extensive study in 1999 suggests that firms are
actually motivated by a concern not to disappoint investor expectations
(see Degeorge et al., 1999), if this may also be motivated by executives’
concern about how they are seen more generally (see Stein, 1989). Watts
and Zimmerman point to accounting manipulation being motivated by
a range of contractual arrangements, including corporate lending and
management compensation.
An issue following on from the above is whether the existence of a
bonus plan for management compensation in corporations impacts upon
accounting practice. For instance, are accounting methods used to increase
current period income at the expense of other periods? Or, if a target
is not going to be met, is income shifted to future periods to maximise
bonuses later (see Watts and Zimmerman, 1986)? It has been found
that US managers approaching their retirement do not invest in research
and development if bonuses are paid on accounting measures that are
negatively impacted by accounting treatment of research and development
Chapter 6: Positive/descriptive economistic theory of accounting
65
(Lewellen et al., 1987; see also Nagar et al., 2003). An alternative may be
to base bonuses on stock market prices. Managerial behaviour might then,
however, be based on their understanding of how accounting numbers
impact stock market prices. Nagar et al. (2003) make the interesting
conclusion that the market-based schemes encourage more disclosure.
A further issue exposed and explored concerns the impact of debt
covenants (e.g. leverage covenants, interest cover ratio covenants,
dividend cover ratio covenants, debt to asset ratio covenants, current ratio
covenants, debt ceilings, prescriptions of conservative accounting methods
in relation to loans, and restrictions on the revaluation of assets in relation
to organisational monitoring by lending institutions – if these latter two
measures are imposed in relation to external accounts it would be in the
confines of what the laws/standards permit, see Mather and Peirson, 2006;
Zhang, 2008). For instance, is it the case that due to covenants, the higher
the gearing or debt/equity ratio, the more likely managers are to choose
methods that increase accounting income? In general, there is a concern
about whether companies choose accounting methods so as to side-step
covenant violations or default. Debt holders often impose covenants
given the riskiness of their investment (e.g. because of the possibility of
making excessive dividend payments, investment in high-risk projects and
incentives to increase the use of debt due to the tax deductibility of debt
interest). Given a concern to avoid higher interest on a loan, companies
may even favour the covenants. Defond and Jiambalvo (1994) found that
the manipulation of accruals was significant the year before and the year
after covenant violations. Sweeney (1994) found financially distressed
firms engaging in earnings management to avoid accounting-based debt
covenants.
Positive accounting theory has also investigated the political costs
hypothesis. Taking size as a proxy for political visibility (and political
attention from governments and government agencies – e.g. regulators
of competition and monopoly, lobby groups) the concern is to investigate
whether larger firms are more likely to choose methods that reduce
reported profits – to mitigate the argument that larger firms profit from
their power and exploitation. Politicians may in this regard use reported
profits to justify action on behalf of the public. Jones (1991) found
that the US government used tariffs on behalf of firms suffering unfair
competition abroad, justification for this being based upon reported
profitability as well as sales. Sutton (1998) found that UK firms engaged in
significant lobbying activity over current cost accounting (which typically
in practice reduces profits when compared with historic cost accounting).
Ness and Mirza (1991) found that voluntary environmental disclosures in
the UK were higher amongst politically sensitive firms such as oil and gas
firms wanting to improve their public image.
6.6 Critique
One issue arising with studies that assume efficient markets (towards the
stronger sense) is that if their assumption is incorrect, markets may not be
very good benchmarks to evaluate choices.
Another issue in the research is that measurements and proxies used are
too simplistic. There is a great deal of debate concerning notions such as
accounting quality, for instance (Dechow et al., 1995). Organisational-
specific relationships and institutional issues are much overlooked.
Positive accounting theory in practice has tended to focus on conflicts
between powerful members of society and ignored those with less wealth.
AC3193 Accounting theory
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Often, the theory has been associated with an anti-regulatory stance, with
this often built on a dubious rhetoric rather than upon the substantive and
cautious interpretation of research findings.
In addition to issues of method and scope already referred to, it is
problematic to assess the usefulness of accounting information by looking
only at share price reactions. More generally, the economistic focus is
relatively narrow given actual and potential dimensions of accounting.
There is also a conservative aspect to positivistic research, given its focus
on real world data and its de-emphasising of alternative possibilities
and visions. Further, much of the research reviewed here is scarcely
challenging the socio-political order – at best it is aiming to improve
things marginally (rather than radically). At worst, it is an apology for
current market functioning, and in its more rhetorical form encourages
an extra-evidential anti-regulatory policy – a tendency that arguably was
pronounced before the financial crisis of 2008.
6.7 Overview of chapter
We sought to clarify further here the distinction between positive
(descriptive) and normative (prescriptive) theory. Of the many kinds
of positive or descriptive theory, this chapter focused upon a particular
kind: positivistic and economistic theorising of accounting. This includes
two broad strands, which overlap: positive accounting theory and efficient
markets theory. Positive accounting theory is perhaps misnamed as it does
not in practice exhaust the label ‘positive’ as used in distinguishing positive
and normative theory. It has, however, made a number of contributions to
theorising accounting in practice. Here we sought to appreciate some key
contributions and to develop a critique. In relation to research concerning
efficient markets theory, we elaborated three kinds of hypothesis that
have been tested in the efficient markets research: the weak form, semi-
strong form and strong form hypotheses. There is an interface with
accounting, most obviously in relation to the semi-strong form and
published accounting information. We sought to clarify the implications
of the efficient markets research for policy, which added to the critical
appreciation.
6.8 Reminder of learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• trace the emergence of positive/descriptive economistic accounting
theory
• elaborate key characteristics of positive/descriptive economistic
accounting theory
• discuss studies that have helped to contribute to positive/descriptive
economistic accounting theory, including in relation to efficient
markets research
• critically evaluate positive/descriptive economistic accounting theory.
Chapter 6: Positive/descriptive economistic theory of accounting
67
6.9 Test your knowledge and understanding
1. Give three illustrations of research seeking to enhance the ‘positive
accounting theory’.
2. Is it reasonable to classify research that seeks to build efficient markets
theory as a positivistic and economistic type of accounting theory?
3. Clarify the meaning of positivistic and economistic accounting theory.
Do you think it could be argued that a key omission from research
building this theory in practice is research about individual and
particular decisions using financial accounting information? Give
reasons for your answer.
6.10 Sample examination questions
6.1 Outline the character of the mainstream positive/descriptive
economistic accounting theory development that has become so prominent
in accounting research, particularly in North America. How is its
prominence explained?
6.2 Critically review the mainstream positive/descriptive economistic
accounting theory that became significant in the 1970s and 1980s.
6.3 Critically assess efficient markets research, giving consideration to its
implications for policy.
6.4 What do Watts and Zimmerman (1986) mean by ‘positive accounting
theory’? Provide some illustrations of this theory and then offer a critique.
Notes
AC3193 Accounting theory
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Chapter 7: Theorising accounting through an interpretive approach
69
Chapter 7: Theorising accounting through
an interpretive approach
7.1 Introduction
In this chapter, we will outline the building of accounting theory
through an interpretive approach. Substantively, this has involved
interdisciplinarity and the use of social, sociological and socio-political
lenses. A range of theories have emerged consistent with the interpreting
of accounting in practice; we will discuss these, along with research that
has contributed to accounting theory development of this kind.
7.1.1 Aims of the chapter
The aim of this chapter is to:
• introduce interpretive approaches to accounting theory.
7.1.2 Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• outline the character of theories consistent with the interpreting of
accounting in practice
• discuss research that has contributed to interpretive accounting theory
• critically evaluate interpretive accounting theory.
7.1.3 Essential reading
Chua, W.F. ‘Radical developments in accounting thought’, The Accounting Review
61(4) 1986, pp.601–32.
Hopper, T., J. Ashraf, S. Uddin and D. Wickramasinghe ‘Social theorisation of
accounting: challenges to positive research’ in, Jones, S. (ed.) The Routledge
companion to financial accounting theory. (London: Routledge, 2015) [ISBN
9781135107253].
Laughlin, R. ‘Empirical research in accounting: alternative approaches and a
case for “middle-range” thinking’, Accounting, Auditing and Accountability
Journal 8(1) 1995, pp.63–87.
Malsch, B. and Y. Gendron ‘Re-theorizing change: institutional experimentation
and the struggle for domination in the field of public accounting’, Journal of
Management Studies 50(5) 2013, pp.870–99.
Malsch, B., Y. Gendron and F. Grazzini ‘Investigating interdisciplinary
translations: the influence of Pierre Bourdieu on accounting literature’,
Accounting, Auditing and Accountability Journal 24(2) 2011, pp.194–229.
Wickramasinghe, D. and C. Alawattage ‘Interpretivism’ in Roslender, R. (ed.)
The Routledge companion to critical accounting. (London: Routledge, 2017)
[ISBN 9781317686736].
7.1.4 Further reading
Deegan, C. and J. Unerman Financial accounting theory. (Maidenhead:
McGraw-Hill Education, 2011) 2nd edition [ISBN 9780077126735].
Chapter 8.
Hoque, Z. (ed.) Methodological issues in accounting research: theories and
methods. (London: Spiramus, 2006) [ISBN 9781910151471] Chapters 9
and 10.
Tomkins, C. and R. Groves ‘The everyday accountant and researching his
reality’, Accounting, Organizations and Society 8(4) 1983, pp.361–74.
AC3193 Accounting theory
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7.1.5 References cited
Alcouffe, S., N. Berland and Y. Levant ‘Actor-networks and the diffusion of
management accounting innovation: a comparative study’, Management
Accounting Research 19(1) 2008, pp.1–17.
Baxter, J. and W. Chua ‘Actor–network theory and critical accounting research’,
in Roslender, R. (ed.) The Routledge companion to critical accounting.
(London: Routledge, 2018) [ISBN 9781317686736].
Berger, P. and T. Luckmann The social construction of reality: a treatise in the
sociology of knowledge. (London: Penguin, 1966)
Berry, T., T.R. Capps, D.J. Cooper, P. Ferguson, T. Hopper and E.A. Lowe
‘Management Control in an area of the NCB: rationales of accounting
practice in a public enterprise’, Accounting, Organizations and Society 10(1)
1985, pp.3–28.
Briers, M. and W.F. Chua ‘The role of actor-networks and boundary objects in
management accounting change: a field study of an implementation of
activity-based costing’, Accounting, Organizations and Society 26(3) 2001,
pp.237–69.
Chua, W.F. ‘Experts, networks and inscriptions in the fabrication of accounting
images: a story of the representation of three public hospitals’, Accounting,
Organizations and Society 20(2–3) 1995, pp.111–45.
Chua, W.F. and H. Mahama ‘On theory as a “deliverable” and its relevance in
“policy” arenas’, Critical Perspectives on Accounting 23(1) 2012, pp.78–82.
Colville, I. ‘Reconstructing “behavioural accounting”’, Accounting, Organizations
and Society 6(2) 1981, pp.119–32.
Covaleski, M.A., M.W. Dirsmith and J.E. Michelman ‘An institutional theory
perspective on the DRG framework, case-mix accounting systems and
health-care organizations’, Accounting, Organizations and Society 18(1)
1993, pp.65–80.
Dillard, J.F., J.T. Rigsby and C. Goodman ‘The making and remaking of
organization context: duality and the institutionalization process’,
Accounting, Auditing and Accountability Journal 17(4) 2004, pp.506–42.
DiMaggio, P.J. and W.W. Powell ‘The iron cage revisited: institutional
isomorphism and collective rationality in organizational fields’, American
Sociological Review 48(2) 1983, pp.147–60.
Gallhofer, S. and J. Haslam ‘Some reflections on the emancipatory accounting
construct: shifting meaning and the possibilities of a new pragmatism’,
Critical Perspectives on Accounting 2017. Advance online publication. doi.
org/10.1016/j.cpa.2017.01.004
Glaser, B. and A. Strauss The discovery of grounded theory: strategies for
qualitative research. (London: Weidenfeld and Nicholson, 1967)
Hopper, T. and M. Major ‘Extending institutional analysis through theoretical
triangulation: regulation and activity-based costing in Portuguese
telecommunications’, European Accounting Review 16(1) 2007, pp.59–97.
Law, J. ‘Notes on the theory of the actor-network: ordering, strategy and
heterogeneity’, Systems Practice 5(4) 1992, pp.379–93.
Pipan, T. and B. Czarniawska ‘How to construct an actor-network: management
accounting from idea to practice’, Critical Perspectives on Accounting 21(3)
2010, pp.243–51.
Preston, A.M. ‘Enabling, enacting and maintaining action at a distance: an
historical case study of the role of accounts in the reduction of the Navajo
herds’, Accounting, Organizations and Society 31(6) 2006, pp.559–78.
Preston, A.M., D.J. Cooper and R.W. Coombs ‘Fabricating budgets: a study of
the production of management budgeting in the National Health Service’,
Accounting, Organizations and Society 17(6) 1992, pp.561–93.
Robson, K. ‘On the arenas of accounting change: the process of translation’,
Accounting, Organizations and Society 16(5–6) 1991, pp.547–70.
Chapter 7: Theorising accounting through an interpretive approach
71
Robson, K. ‘Accounting numbers as “inscription”: action at a distance and the
development of accounting’, Accounting, Organizations and Society 17(7)
1992, pp.685–708.
Rosenberg, D., C. Tomkins and P. Day ‘A work role perspective of accountants
in local government service departments’, Accounting, Organizations and
Society 7(2) 1982, pp.123–37.
Tomkins, C., Rosenberg, D. and I. Colville ‘The social process of research:
some reflections on developing a multi-disciplinary accounting project’,
Accounting, Organizations and Society 5(2) 1980, pp.247–62.
Young, J. ‘Institutional thinking: the case of financial instruments’, Accounting,
Organizations and Society 21(5) 1996, pp.487–512.
7.2 The basic character of interpretive accounting theory
Interpretive approaches to accounting theory development, leading to the
production of interpretive accounting theory, may be characterised
in a number of ways.
An ideal typical approach to building interpretive accounting theory
tends to be strongly inductive, constructing accounting theory from the
ground up, as it were. Consistent with this, it aims to be a very open
approach to theory development. At the same time, an interpretive
theory can be characterised by themes that guide theory development
(see below). An interpretive theory approach would also tend towards
a very strong subjectivist orientation, leading it to acknowledge the role
of hermeneutics, or interpretation, of the researcher and researcher
interpretation of the interpretations of the researched (double
hermeneutics) for accounting theory development. It often places
emphasis on the subjectivist interpretations of the social actors who
are focused upon and/or who are the source of the insights into the
construction of the accounting theory. Theory has not been constrained
here (in the context of developing accounting theory) through the
lens, concepts and constructs of mainstream economics; in practice,
interpretation in interpretive accounting theory construction is dominated
by and is open to interdisciplinary perspectives, which have substantively
drawn much from social and political perspectives.
It is theoretically naïve to believe that we can in an absolute sense
simply build theory from the ground up as if researcher intervention was
of no consequence to the research act. A canvas is never purely blank; the
outline is already in some way imagined. The researcher’s very choice of
what to observe indicates already thematic biases and tendencies. There
are always some preconceptions in the act of theory construction and
development – the best we can do is to seek to be as open as possible
throughout the research process and to engage in a deep form of critical
reflexivity (see Bernstein’s, 1976, comments on the phenomenological
alternative; see Laughlin, 1995).
In practice, interpretive researchers have pursued particular themes and
engaged in telling particular stories as they have proceeded in research and
the development of interpretive accounting theory. Given the commitment to
openness, there has been a variety of, or a heterogeneity of, interpretations.
Here, we find debates about where interpretive accounting theory ends
and critical accounting theory (see Chapter 8) begins. You may argue that
a critical interpretive theory is a particular kind of interpretive theory in
which critical themes are given emphasis to a degree, whereby the theory
is explicitly classified or categorised as critical; there is clearly a degree of
arbitrariness here as to where any line of demarcation may be drawn.
AC3193 Accounting theory
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As Wickramasinghe and Alwattage (2018), in a contribution to Roslender’s
(2018) collection, point out, the interpretive character of interpretive
accounting theory may also be understood as facilitating the bringing
of actors, their agency and their practices, into the forefront of
theoretical analysis.
7.3 Relatively early interpretive accounting theory
contributions
In accounting research, the interpretive approach (which is sometimes
confusingly referred to as the ‘naturalistic’ approach) was especially
promoted in the 1970s and 1980s (see Tomkins et al., 1980; Colville,
1981; Rosenberg et al., 1982; Tomkins and Groves, 1983). The early
emphasis of its advocates was to encourage in-depth and subjective
research using a variety of methods (but especially the qualitative methods
that researchers of a more subjectivist orientation tend to prefer). Key
advocates of an interpretive approach delineated a theoretical position and
the journal Accounting, Organizations and Society, established in 1976, was
facilitative of this process. A prior source influencing these developments
included behavioural accounting research, with its interdisciplinary
concerns to bring in industrial psychology and sociology to articulate and
elaborate the social and psychological implications of accounting practices.
In the early promotion of interpretivism in the theorising of accounting
processes and accounting theory development (that is, that of the
1970s and 1980s), there was effectively emphasis upon the interpretive
sociology of Weber, Mead, Cowley and Blumer, especially the symbolic
interactionism, ethnomethodology and phenomenology associated with
these writers, as providing key insights to draw upon (Wickramasinghe
and Alwattage, 2018).
Colville’s (1981) paper on local government accounting practices in some
key ways approximated the ideal typical approach to building interpretive
accounting theory outlined above. It embraced an attempt to build
accounting theory up from the ground, being much influenced by the call
of Glaser and Strauss (1967) for ‘grounded theory’. Colville (1981) also
gives emphasis to the view that accounting and accounting processes are
socially constructed (as per Berger and Luckmann, 1966). Berry et
al. (1985) presented a study with several similar characteristics that also
provides rich material and insights. Focusing on how/why managers at
the National Coal Board constructed, interpreted and used accounting in
practice, Berry et al. concluded that the form of accounting pursued at the
local level was decoupled from the formal control protocols that ostensibly
were meant to operate.
Many of the interpretive accounting research studies conducted in the
1970s and 1980s focused more on management accounting or internal
accounting practices than they did on financial or external accounting
practices. This relative emphasis has continued.
7.4 More recent variants of interpretive accounting
theory
Since the 1970s and 1980s, a greater variety of social and socio-political
theory has been drawn upon to develop thematisation in interpretive
accounting theory.
The range of theories discussed is often very wide but, commonly,
institutional theory, actor-network theory (ANT), Bourdieusian theory
Chapter 7: Theorising accounting through an interpretive approach
73
and legitimacy theory (and stakeholder theory, which can be considered a
variant of legitimacy theory) are considered as contributing to accounting
theories in the category of interpretive accounting theory. Aside from
noting overlaps and interfaces between these particular theories in
accounting, we should note that they have all been seen as or associated
with critical accounting (see Chapter 8) perspectives – indicating the
somewhat arbitrary nature of accounting theory delineation. These
overlaps and associations will be referred to in the discussion below.
We may already note in relation to the critical dimension that some
commentators see these ‘interpretive’ theories as yielding many insights
into the subtlety of domination through routine and mundane practices
of accounting, which is sometimes contrasted with an alleged blunter or
cruder approach in some critical accounting theory (see Wickramasinghe
and Alwattage, 2018).
Institutional theory’s influence is evident in the theory construction of
Covaleski et al. (1993) and Dillard et al. (2004). A key insight from
institutional theory (and this key insight could clearly be articulated as a
critical position, at the very least in raising questions and problematising
institutional processes) is that the relevance of practices and ways of
doing things for economic effectiveness and efficiency is not the only
driving force for their adoption and spread. Homogeneous practices
arising in the governance of the social and institutional have their roots
in, or are substantively shaped by, socially embedded norms, values and
shared meanings at work and how these interact with directions and
possibilities from a dynamic contextual field (see DiMaggio and Powell,
1983; Wickramasinghe and Alwattage, 2018). Drawing from such an
insight, accounting theory shaped by institutional theory has tended to
see accounting as entailing a process of conformity with the institutional
environment of which it is part. Such theorising can be applied to the
interface between local practices and the globalised context, involving, for
instance, the promotion of international accounting standards.
Young (1996) traces how local accounting initiatives are informed and
shaped by widely accepted and idealised accounting practices. Young
shows how US accounting standard setters are influenced by a taken-for-
granted acceptance that financial markets are inherently efficient and
that accounting provides relevant information for decision-makers in such
contexts. This view has its merits (more problematic interpretations of
the efficient markets research are possible, as we saw in Chapter 6) but
as Young correctly notes, it encourages an overlooking of other behaviour
in financial markets and substantively delimits possibilities for accounting
prescription. Similar insights that might also be regarded as ‘critical’ ones
are brought forth in Malsch and Gendron (2013) who refer to interests,
power and resistance in the ‘institutional field’, a terrain of struggle where
different actors compete.
In relation to the structure–agency debate, much institutional theory
usage in accounting research tends to emphasise the significance of
structural dimensions and processes (giving stress to an institutionalisation
seen as substantively unidirectional). But studies focused on the
emergence of ambivalence in accounting functioning have encouraged
more emphasis in effect on agency and the dynamic issues engendered
by agential interactions, typically in micro-organisational settings.
Malsch and Gendron (2013), in the context of accounting theorising,
see institutionalisation as an indeterminate possibility. In research on
‘institutional’ work, researchers have sometimes emphasised the primacy
of the agency of actors.
AC3193 Accounting theory
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ANT’s influence and language/terminology is seen in studies such as
Preston et al. (1992), Chua (1995), Briers and Chua (2001), Preston
(2006), Alcouffe et al. (2008), Justesen and Mouritsen (2010), Pipan and
Czarniawska (2010) and Chua and Mahama (2012). ANT explores how
ideas, concepts, practices and technologies develop through networks of
relationships (that are in many ways heterogeneous and that are formed
and reformed through time and space). Preston et al. (1992), in a study
of internal accounting practices, show how budgets are fabricated. The
budgets in the study are seen as being used as a pre-existing natural order
imposed on lower participants; the micropolitics of the organisational
context is seen in terms of heterogeneous actors being enrolled into a
local network to decide upon budgets and to create a forum for these
actors to engage in continuous endorsements until budgets are accepted
(Wickramasinghe and Alwattage, 2018).
Robson (1991, 1992) understands accounting as a form of inscription,
where actors can act at a distance in order to make things visible,
engendering various consequences of import. Less emphasis is typically
placed on hierarchical relationships in ANT as ANT sees an on-going
struggle in which, as in post-structuralist theorising, power is not
only held by a particular protagonist; while there are conditions of
possibility for trajectories and outcomes, there are numerous possible
processes that cannot be so easily anticipated in advance and that one
needs to seek to carefully appreciate (see Law, 1992; Gallhofer and
Haslam, 2017). Baxter and Chua (2018) offer a very useful articulation of
ANT in relation to critical theory concerns. And Hopper and Major (2007)
combine ANT with a critical labour process theory of accounting in their
theorising of accounting.
Wickramasinghe and Alwattage (2018) summarise some of the implications
of ANT in terms of method. They see the researcher or researchers
following the actors in interviews, conversations and observations to make
sense of how accounting is presented in relationships and actions. The
researcher here in following the actors and seeing accounting’s continuing
manifestations, experiences processes of translation and fabrication, as
well as making and remaking, and thus gains understanding of how issues
are problematised and new actors become ‘interested’.
Malsch and Gendron (2013) is a study that indicates both how
Bourdieu can be combined with institutional theory and how usage of
Bourdieu in developing accounting theory raises lots of insights that
may also be considered elements of a critical theorising of accounting.
As Wickramasinghe and Alwattage (2018) point out, many accounting
researchers have borrowed the interrelated concepts of field (which
has been a great encouragement to ethnographic methods in accounting
research), capital and habitus from Bourdieu. Field is a terrain of
struggle between social actors. Capital held by actors in a field is either
economic, social/symbolic or cultural. Habitus can be understood in terms
of the mental and cognitive structures through which people deal with the
social structures that are internalised through life experiences in fields that
tend to encourage the reproduction of the character of the field. Several
accounting research studies that might be described as contributions to
interpretive accounting theory have been made here (see the review of
Malsch et al., 2011; see also Wickramasinghe and Alwattage, 2018).
Legitimacy theory is often used to theorise various accounting
disclosures of companies, especially so-called voluntary disclosures
(and more especially in areas such as corporate social responsibility
reporting). Legitimacy theory aims to show how key societal institutions,
Chapter 7: Theorising accounting through an interpretive approach
75
including business organisations, seek to gain legitimacy in the eyes of key
stakeholders. This can be linked to a critical way of theorising (see Chapter
8), especially if business corporations seek to attain the legitimacy through
dubious processes of information manipulation and hiding and if the
public are persuaded by these dubious practices. Legitimacy theory notions
are often articulated in relation to institutional theory since one dimension
of organisational functions that may motivate institutions to pursue
various forms of isomorphism is a concern to appear legitimate (see
Deegan and Unerman, 2011, Chapter 8). Deegan, in Chapter 9 of Hoque’s
text, sees legitimacy theory as an interpretive mode of accounting theory
that is useful in mobilising dimensions of critique. Stakeholder theory may
be understood for our purposes here as a form of legitimacy theory that is
concerned to articulate and delve into how organisations seek to remain
legitimate in the eyes of their particular and/or key stakeholders. This can
often result in analyses similar to those employing legitimacy theory.
Activity 7.1
• Read Malsch and Gendron (2013) and Malsch et al. (2011).
• What insights does Bourdieu offer to accounting theory?
• Explain the key terms of a Bourdieusian analysis as seen by Malsch et al.
• Delineate two illustrations of accounting research drawing from Bourdieu based on
Malsch et al.
7.5 Critique
Research and theory development that embraces intellectual and empirical
enquiry (in order to raise issues that may otherwise be glossed over) has
definite strengths. Openness in theory building is also a strength that we
should seek to encourage as it can yield a range of insights. An issue is that
external accounting is under-researched from an interpretive accounting
theory perspective.
Chua (1986) sets out many of the strengths and weaknesses of an
interpretive approach to accounting theory construction and development.
One key weakness is arguably the way it is seen as in some significant
senses different from critical approaches to accounting theory construction
(clearly this may be read as in part a critique of the classification and
categorisation schemes that have been influential in this area). Another
issue concerns demarcation from economistic perspectives, when
economistic dimensions can surely be useful for enhancing the story-telling
that is integral to interpretive accounting theory. There is also naivete about
pure observational possibilities as distinct from a striving for openness.
Activity 7.2
Consider two sets of journals in accounting:
• Set 1 = Journal of Accounting Research and Accounting Review
• Set 2 = Accounting, Auditing and Accountability Journal and Accounting,
Organizations and Society
Review recent editions of these journals (you may initially focus on the first journals
mentioned in each set).
What do you notice that is different about the studies published in these journals in terms
of what you have read in the guide so far?
AC3193 Accounting theory
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7.6 Overview of chapter
Interpretive theory represents an alternative direction to the positivistic
and realist theory that has dominated much accounting research (most
obviously in North America). Both these theories are positive (in the
sense of not being normative) – or alternatively, they both have a positive
emphasis rather than a normative emphasis. But interpretive theory is
more subjectivist in its underlying philosophical orientation, and theory
tends to be developed by more qualitative research methods.
We discussed early attempts to develop interpretive theory. We then
focused upon instances of interpretive theory that have become
influential in accounting research. We focused here on institutional
theory approaches, actor-network theory and theory that has drawn from
the work of Pierre Bourdieu. Such theorising has enhanced and refined
accounting theory – especially as a theory of accounting in practice, in
the context of which it is part. It is difficult to appreciate where such
theorising ends and ‘critical’ theorising begins. Institutional theorising
has clear critical reference and some see it as a kind of critical theory in
another language (see Gallhofer and Haslam, 2017). Baxter and Chua
(2018) indicate the linkages and overlaps between actor-network theory
and a critical theoretical approach. The themes of Bourdieu, especially
around his notions of ‘capitals’, are clearly consistent with a critical
perspective and Bourdieu himself spoke of the need to be concerned to
change things in a way that was consistent with conventional critical
orientations. We offered here a critique of interpretive theory.
7.7 Reminder of learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• outline the character of theories consistent with the interpreting of
accounting in practice
• discuss research that has contributed to interpretive accounting theory
• critically evaluate interpretive accounting theory.
7.8 Test your knowledge and understanding
1. From Chua (1986), what are the key differences between an
interpretive approach and a functionalist approach?
2. What is the relationship between positivism and functionalism?
3. Outline dimensions of institutional theory, Bourdieusian theory and
actor-network theory. What is their relevance to accounting theory?
7.9 Sample examination questions
7.1 What do you understand by ‘interpretive accounting theory’? Compare
and contrast interpretive accounting theory with the more positivistic and
functionalist accounting theory (which may be described as positive or
descriptive economistic accounting theory) that has become so dominant
in the North American context.
7.2 Critically evaluate that type of accounting theory that is categorised as
interpretive accounting theory.
7.3 Is there scope for a greater emphasis on economistic dimensions in
building interpretive accounting theory?
Chapter 7: Theorising accounting through an interpretive approach
77
7.4 Critically assess contributions to accounting theory development that
have drawn upon actor-network theory and/or institutional theory.
7.5 Critically assess the influence of Bourdieu on interpretive accounting
theory
7.6 What do you understand by legitimacy theory and/or stakeholder
theory? How are these theories helpful in the appreciation of accounting
practice?
Notes
AC3193 Accounting theory
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Chapter 8: Critical accounting theory
79
Chapter 8: Critical accounting theory
8.1 Introduction
This chapter introduces ‘critical’ accounting theory. In what sense is it a
distinct category of theorising? We consider different varieties of critical
accounting theory and critically assess such theory.
8.1.1 Aims of the chapter
The aims of this chapter are to:
• discuss the construct of critical accounting theory
• elaborate, in terms of its key characteristics, critical accounting theory
• outline research that has contributed to critical accounting theory
development
• offer a critique of critical accounting theory.
8.1.2 Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• explain key characteristics of critical accounting theory
• discuss studies that have helped to contribute to critical accounting
theory
• critically evaluate critical accounting theory.
8.1.3 Essential reading
For this chapter, the Essential reading is this chapter itself. However, other
readings can also be considered essential in getting on top of the material
in the chapter. The introductory remarks of Roslender referenced below
may be helpful, as well as Chua. Gallhofer and Haslam offer an overview
of the history of the ‘emancipatory accounting’ construct that is important
in the articulation of prescriptive critical accounting theory.
Chua, W.F. ‘Radical developments in accounting thought’, The Accounting Review
61(4) 1986, pp.601–32.
Gallhofer, S. and J. Haslam ‘Some reflections on the emancipatory accounting
construct: shifting meaning and the possibilities of a new pragmatism’,
Critical Perspectives on Accounting 2017. Advance online publication. doi.
org/10.1016/j.cpa.2017.01.004
Laughlin, R. ‘Empirical research in accounting: alternative approaches and a
case for “middle-range” thinking’, Accounting, Auditing and Accountability
Journal 8(1) 1995, pp.63–87.
Roslender, R. ‘Introduction’ in Roslender, R. (ed.) The Routledge companion to
critical accounting. (London: Routledge, 2017) [ISBN 9781317686736].
8.1.4 Further reading
Cooper, D.J. and M.J. Sherer ‘The value of corporate accounting reports –
arguments for a political economy of accounting’, Accounting, Organizations
and Society 9(3/4) 1984, pp.207–32.
Roslender, R. ‘Critical theory’ in Hoque, Z. (ed.) Methodological issues in
accounting research: theories and methods. (London: Spiramus, 2006) [ISBN
9781910151471].
Spence, C. ‘Social accounting’s emancipatory potential: a Gramscian critique’,
Critical Perspectives on Accounting 20(2) 2009, pp.205–27.
AC3193 Accounting theory
80
Tinker, T. Paper prophets: a social critique of accounting. (London: Holt, Rinehart
and Winston, 1985) [ISBN 9780039106416].
Unerman, J. and M. Bennett ‘Increased stakeholder dialogue and the
internet: towards greater corporate accountability or reinforcing capitalist
hegemony?’, Accounting, Organizations and Society 29(70) 2004, pp.685–
707.
8.1.5 References cited
Collison, D.J. ‘Corporate propaganda: its implications for accounting and
accountability’, Accounting, Auditing and Accountability Journal 16(5) 2003,
pp.853–86.
Gallhofer, S. and J. Haslam ‘The aura of accounting in the context of a crisis:
Germany and the First World War’, Accounting, Organizations and Society
16(5–6) 1991, pp.487–520.
Gallhofer, S., J. Haslam and A. Yonekura ‘Accounting as differentiated
universalism for emancipatory praxis: accounting delineation and
mobilisation for emancipation(s) recognising democracy and difference’,
Accounting, Auditing and Accountability Journal 28(5) 2015, pp.846–74.
Tinker, T. (ed.) Social accounting for corporations: private enterprise versus the
public interest, (Manchester: Manchester University Press, 1984) [ISBN
9780719017551].
Tinker, T. ‘The accountant as partisan’, Accounting, Organizations and Society
16(3) 1991, pp.297–310.
8.2 Delineation of critical accounting theory
The three basic dimensions of an approach that may be labelled ‘critical’
are:
• an aim to develop a theory of external accounting in practice that
indicates a problematic dimension of this accounting
• an envisioning of a better accounting in practice
• a desire to move from the current state of affairs to a better state.
It is possible, in this regard, to argue that all research seeking to develop
accounting theory could be appropriately labelled ‘critical’. Suppose we
first accept that a researcher in the very act of research (most obviously
in the study of social phenomena such as accounting) is perceiving some
aspect of the current context implicating accounting (or the interface
of accounting and the context of which it is part) problematic. Then
we may conclude that this perception impacts upon the research project
(and its development of a theory of accounting) in some way. The very
perception of something problematic concerning the interface between
accounting and context that is bound up in this research act may be
taken to imply some envisioning of a better state. Research and theory
development would in some way be influenced by the desire to move from
the current to the better state. You might ask, in this regard, who is not
critical in doing accounting research (or indeed more generally)?
In the accounting literature, however, there are two main interpretations
of ‘critical’ in relation to ‘critical accounting theory’ that are somewhat
narrower than the above. They involve categorisation, which always
involves (as we argued earlier) some over-simplification and crudeness.
The first understanding of ‘critical’ within these two main interpretations
distinguishes theory that goes beyond the ‘mainstream’ (called as such
because it is so prevalent, especially in North America) positivistic
economistic accounting theory (see Chapter 6) as ‘critical’ accounting
theory. Thus, the theory discussed in the previous chapter is categorised as
Chapter 8: Critical accounting theory
81
critical, whereas the theory discussed in the chapter before that (Chapter
6) is categorised as not critical.
The second approach, which is followed in this chapter, is to see ‘critical’
accounting theory as the theorising of accounting in order to engender
radical social change and hence linked to a radical social philosophy.
What is included in that philosophy is open to contention. For some,
approaches substantially located in the social philosophy of Marx (e.g.
drawing inspiration from Marx himself, Lukacs, Gramsci, the Frankfurt
School of Critical Theory, including Habermas, and Braverman), constitute
the ‘critical’ accounting theory approaches. A liberal current in the
theorising of accounting in the Western world has facilitated the rise of
such theorising of accounting in the literature. Tinker (1984, 1985) was
strongly influenced by Marxist thought in theorising external accounting.
Some might see writers building postmodern, post-structuralist and post-
Marxist lenses (such as Derrida, Foucault, Laclau and Mouffe) as refining
critical perspectives that can still be seen to have strong roots in Marx or
the writers of the 1920s seeking to revise his thought. Others see these
writers as different – either as not especially offering critical theorising
or as offering a very different kind of critical theorising from Marx (which
might in some ways subsume Marx as an instance of a much wider
theorising – for instance, Foucault may be understood as highlighting
processes of subjectification that includes the particular phenomena
highlighted by Marx).
At the same time, other categorisations, such as Laughlin (1995), set up
more critical or less critical theoretical perspectives on accounting as a
continuum that helps constitute other categories (of empirical approaches
to accounting research). The notion of a continuum can be reconciled
to the above schema, however; one can take an arbitrary point on the
continuum and define approaches more critical than approaches at that
point as ‘critical’ and approaches less critical than approaches at that point
as ‘not critical’.
Activity 8.1
• Do you agree that all accounting theory could be termed ‘critical’?
• What for you are the key characteristics of a critical accounting theory worthy of the
name?
8.3 Some themes of critical accounting theorising: too
negative?
One issue that has arisen in critical perspectives on accounting is that they
have tended to focus on negative dimensions of accounting. Spence
(2009) argues that most accountings produced in society are captured by
powerful hegemonic, conservative and problematic forces in society rather
than being linked to socially progressive change. More generally,
critical appreciations have tended to point through socio-institutional or
political economy analyses to accounting’s interested nature – they have
suggested that accounting serves powerful private interests rather than
the public interests that the profession and government claim accounting
serves (or, in approaches influenced by post-structuralist and postmodern
perspectives, there is an emphasis on the more general negative influences
of accounting as thought and practice).
The point made by Spence (2009) and other critical writers is pessimistic
about types of accounting such as social accounting and corporate social
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responsibility reporting. Such accounting typically takes a stakeholder-
orientated approach and goes beyond conventional financial accounting;
it is not restricted to either the financial and numerical and can include,
for instance, reports on worker and customer satisfaction, impact
on the ecological environment and many other issues of social and/
or environmental concern. Such accounting, produced by business
organisations and potentially regulated by the state, is seen by some as
a progressive step beyond conventional financial accounting (hence a
kind of prescriptive accounting theory emerging from a critique of that
conventional accounting). But Spence (2009) and others find it easily
captured by forces that are powerful and problematic from a critical
perspective (see Collison, 2003).
Some critical theorising of accounting sees accounting in more ambivalent
terms (or ambiguous terms in that sense). Gallhofer and Haslam (1991)
argue that even a conventional financial accounting can serve radically
progressive forces in society in the right conditions (involving changes
in one or more elements or dimensions of accounting and/or the wider
context of accounting’s location).
A notion of accounting that can be socially progressive and emancipatory
has emerged in the literature – a kind of prescriptive critical theory.
Initially this was constructed as a pristine ‘emancipatory accounting’
that would help bring about a revolution. Tinker’s (1984, 1985) usage
of the construct emancipatory accounting is consistent with that and
is elaborated in a Marx inspired line of thought. Spence’s (2009) view,
drawing from Gramsci, that the only accounting that may bring about
emancipatory change is accounting produced to challenge business
organisations and the state, produced by campaigners concerned to
make such a challenge (terms such as ‘shadow accounting’ and ‘counter
accounting’ have been used) has a similar connotation to Tinker’s notion
of emancipatory accounting (even if Tinker’s particular notion of it in 1984
and 1985 was a narrower, more economistic, conceptualisation).
An emphasis on ‘continuum thinking’ is apparent in Gallhofer and Haslam
(2017) and Gallhofer et al. (2015). In relation to radical social philosophy,
Gallhofer and Haslam (2017) seek to develop critical accounting thought
through engagement with postmodern, post-structuralist and post-Marxist
thinking. They conclude that at any moment in time accounting practice
is a mix of socially progressive and regressive forces and that its impact
on society is complex and ambivalent – it is crucial to look at the detail of
its impact. Moreover, they suggest, accounting can become (in terms of its
overall impact) ‘more emancipatory’ or ‘less emancipatory’ over time in
changing conditions. Their argument applies to any type of accounting,
whether conventional financial accounting, social accounting or counter
accounting. This can be taken as expanding prescriptive dimensions
of critical accounting theory, since prescription is neither confined to
the counter accounting promoted by Spence and others, nor the social
accounting that is advocated by some as an alternative to conventional
accounting; it also encompasses various aspects and possibilities of even
the accounting that has been labelled ‘conventional’ and made the central
target of critique (see Gallhofer and Haslam, 1991; Gallhofer et al., 2015;
Gallhofer and Haslam, 2017).
Chapter 8: Critical accounting theory
83
Activity 8.2
Read Gallhofer and Haslam (2017).
• How do they understand ‘emancipatory accounting’ today?
• What do they see as the possibilities of this understanding?
• What are the characteristics of their ‘critical’ theory of accounting?
• What is its relationship to other theories of accounting?
8.4 Critique
Critical accounting theory, rather like the interpretive accounting
theory discussed in the last chapter, has often given an impression that
a quantitative methods approach to accounting theory development is
inappropriate. Actually, while the ontology and epistemology of much
critical accounting theory (beyond what is implied in emphasising the
case for radical change), is akin to interpretivism, just as with interpretive
approaches more generally, such critical accounting theory development
should not outlaw the quantitative; more generally, one might ask, is it
never valid to count anything? Rather, the underlying philosophy, since it
is often more subjectivist, tends to highlight strengths of more interpretive
approaches to theory construction and weaknesses of the more positivistic
approaches. Critical accounting theory development is also influenced
by researchers who are more objectivist, as in the critical realist and
structural Marxist approaches (see Roslender, 2018) – interestingly, there
is little usage of quantitative method in this context either.
Gallhofer and Haslam (2017) pose some interesting questions about
usage of the label ‘critical’ in accounting research and accounting theory
development. They point to advantages and disadvantages in this
explicit labelling. There are advantages in articulating a position and
being open. There may be disadvantages, at the same time, in reducing
communicative interaction with those for whom the word ‘critical’ (in the
sense used in this chapter) is something of a taboo, perhaps especially in
the context of research enquiry and theoretical development. They suggest
a nuanced usage of the term and indicate that many ‘critical’ accounting
researchers do not feel it necessary to use the term, as indicated in several
contributions to Roslender’s (2018) compilation.
Overall, however, and in substance, critical accounting theory today, in its
many variants (notably as influenced by post-structuralist, postmodern
and post-Marxist theoretical movements of the humanities and the social
sciences), represents a major progressive form of accounting theorising. It
seeks to understand accounting as a socially embedded phenomenon and
practice in ways that problematise dimensions of the interface between
accounting and the context of which it is part. In doing so, it has drawn
from insights in social and political theory and advanced interdisciplinary
perspectives. It envisions, in some way, better states for both accounting
and its context and seeks to achieve these better states. Whether this be a
quite explicit project or less so, it appears to be a worthy one.
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8.5 Overview of chapter
The chapter began with a very broad delineation of ‘critical accounting
theory’, provocatively asking ‘what theorist is not critical?’ We then
considered how critical accounting theory has been understood and
suggested that it has typically focused upon the negative dimensions of
accounting in practice (e.g. pointing to accounting’s role in practice as
serving powerful private interests rather than the public interest). We
discussed the notion of a normative (prescriptive) critical accounting
theory, giving attention to Gallhofer and Haslam’s work (especially
Gallhofer and Haslam, 2017) on the notion of ‘emancipatory accounting’.
Finally, we offered a critique of critical accounting theory.
8.6 Reminder of learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• explain key characteristics of critical accounting theory
• discuss studies that have helped to contribute to critical accounting
theory
• critically evaluate critical accounting theory.
8.7 Test your knowledge and understanding
1. What are the three key dimensions of a critical orientation?
2. How have these been translated into most critical accounting theory?
3. What position does the construct ‘emancipatory accounting’ have in
critical accounting theory?
8.8 Sample examination questions
8.1 When accounting researchers refer to ‘critical’ accounting research,
what do they mean? Do you think it is helpful to explicitly distinguish a
branch of accounting theory as ‘critical’?
8.2 How has the construct of ‘emancipatory accounting’ changed in its
meanings and possibilities since the 1980s?
8.3 Critically evaluate critical accounting theory.
8.4 Delineate or outline critical accounting theory and positive/descriptive
economistic accounting theory. Compare and contrast these types of
accounting theory.
8.5 Critically evaluate a particular contribution to critical accounting
theory.
Chapter 9: Theorising of accounting regulation I: normative/prescriptive theorising
85
Chapter 9: Theorising of accounting
regulation I: normative/prescriptive
theorising
9.1 Introduction
Chapters 9 and 10 focus on accounting regulation. In doing so, they reflect
insights from the earlier chapters concerning the nature of theory and
theorising in accounting. This chapter elaborates upon and discusses the
regulation of accounting, focusing on normative or prescriptive theorising
of accounting regulation. The next chapter, Chapter 10, will consider
approaches to the theorising of accounting regulation that are more
positive or descriptive.
9.1.1 Aims of the chapter
The aims of this chapter are to:
• introduce the theory behind accounting regulation
• discuss the arguments for and against accounting regulation.
9.1.2 Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• explain and discuss various dimensions of accounting regulation
• critically evaluate existing normative/prescriptive theory of accounting
regulation
• begin to articulate a theoretical position on accounting regulation.
9.1.3 Essential reading
Deegan, C. and J. Unerman Financial accounting theory. (Maidenhead:
McGraw-Hill Education, 2011) 2nd edition [ISBN 9780077126735].
Chapter 3.
Gallhofer, S. and J. Haslam ‘Approaching corporate accountability: fragments
from the past’, Accounting and Business Research 23(1) 1993, pp.20–30.
Gallhofer, S. and J. Haslam ‘Exploring social, political and economic dimensions
of accounting in the global context: the International Accounting Standards
Board and accounting disaggregation’, Socio-Economic Review 8(4) 2007,
pp.633–64.
9.1.4 Further reading
Beaver, W.H. Financial reporting: an accounting revolution. (Harlow: Prentice-
Hall, 1981) [ISBN 9780133161410] Chapter 7.
Gallhofer, S. and J. Haslam Accounting and emancipation: some critical
interventions. (New York, NY: Routledge, 2003) [ISBN 9780415220149].
9.1.5 References cited
Akerlof, G.A. ‘The market for “lemons”: quality uncertainty and the market
mechanism’, Quarterly Journal of Economics 84(3) 1970, pp.488–500.
ASSC The corporate report. (London, 1975)
Collett, P. ‘Standard setting and economic consequences: an ethical issue’,
ABACUS 31(1) 1995, pp.18–30.
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Cooper, K. and G.D. Keim ‘The economic rationale for the nature and extent of
corporate financial disclosure regulation: a critical assessment’, Journal of
Accounting and Public Policy 2(3) 1983, pp.189–205.
Demski, J. and G. Feltham Cost determination: a conceptual approach. (Ames,
IA: Iowa State University Press, 1976) [ISBN 9780813803609].
Gallhofer, S. and J. Haslam ‘Reflections on the emancipatory accounting
construct: shifting meaning and the possibilities of a new pragmatism’,
Critical Perspectives on Accounting 2017. Advance online publication. doi.
org/10.1016/j.cpa.2017.01.004
Hakansson, N.H. ‘Interim disclosure and public forecasts: An economic analysis
and framework for choice’, The Accounting Review 52(2) 1977, pp.396–426.
Lipsey, R.G. and K. Lancaster ‘The general theory of second best’, The Review of
Economic Studies 24(1) 1957, pp.11–32.
Morris, R.D. ‘Corporate disclosure in a substantially unregulated environment’,
ABACUS 20(1) 1984, pp.52–86.
Myddelton, D. Unshackling accountants. (London: IEA, 2004) https://iea.org.
uk/wp-content/uploads/2016/07/upldbook241pdf.pdf
Scott, W. Financial accounting theory. (Upper Saddle River, NJ: Prentice-Hall,
2003) [ISBN 9780130655776].
Skinner, D.J. ‘Why firms voluntarily disclose bad news’, Journal of Accounting
Research 32(1) 1994, pp.38–60.
Spence, C. ‘Social accounting’s emancipatory potential: a Gramscian critique’,
Critical Perspectives on Accounting 20(2) 2009, pp.205–27.
Walker, R.G. ‘Australia’s ASRB: A case study of political activity and regulatory
capture’, Accounting and Business Research 17(67) 1987, pp.269–86.
Watts, R.L. and J.L. Zimmerman ‘Towards a positive theory of the determination
of accounting standards’, The Accounting Review 53(1) 1978, pp.112–34.
Watts, R.L. and J.L. Zimmerman Positive accounting theory. (Englewood Cliffs,
NJ: Prentice-Hall, 1986) [ISBN 9780136861713].
9.2 Accounting regulation: context
We have discussed in earlier chapters issues concerning accounting
delineation. Attempts to define or delineate accounting, which involve
articulation of some sort of role of accounting in society, are influenced by
the overlaps and tensions between normative or prescriptive approaches
to the appreciation of accounting and positive or descriptive approaches
thereto. If we want to answer the question ‘What is accounting?’ then
we inevitably will be influenced by a vision of what accounting’s role in
society is normatively or prescriptively taken to be.
Many accounting academics and policy-makers have come around to
emphasising a view of accounting as a social practice that is meant
to serve the public interest by serving the economy or reflecting what is
needed by the economy.
To put this in perspective, in the more normative and prescriptive sphere
of reasoning, it is worth recalling that for many centuries the view that
accounting’s role should be confined to improving economic decision-
making and control has not been something unanimously agreed upon.
For instance, notions that record-keeping may control against types of
fraud and at the same time more generally instil a moral order have been
very influential in religious communities.
In the context of the enlightenment and the rise of modernity – this
being prior to the establishment in the Western world of a formally
organised accountancy profession – many writers subsumed appreciation
of what we think of as external accounting today within a more general
appreciation of openness and transparency. In many ways, a particularly
Chapter 9: Theorising of accounting regulation I: normative/prescriptive theorising
87
good example or illustration is the approach outlined in the works of the
English philosopher Jeremy Bentham (1748–1832), which is summarised
and discussed in Gallhofer and Haslam (2003, Chapter 2). Bentham
understood ‘publicity’ and ‘accounting publicity’ as transparency
and openness in society, for instance the transparency and openness
of an individual, an institution or an organisation. This view included
financial and non-financial dimensions and economic and non-economic
dimensions. Bentham clearly holds that accounting publicity can be
helpful in improving the economic functioning of, for example, business
organisations and other bodies in society and thus can make a contribution
to well-being through acting in the economic sphere (indeed, Bentham
proposed several ways in which what we now think of as financial
accounting could be improved so that it would reflect greater rationality
and become more relevant for economic decisions). But he stresses that
the more important function of accounting publicity was a more
general ethical one: accounting publicity, across and beyond the economic
sphere (embracing today what many term social accounting or see in
terms of corporate social responsibility reporting) could help improve
organisational and social behaviour and in this way, make an even more
significant contribution to well-being (see Gallhofer and Haslam, 1993).
Activity 9.1
Read Gallhofer and Haslam (1993).
In what sense do you think that reading about writings on accounting from several
hundred years ago can be relevant for today?
9.3 Prescriptive theory and accounting standards
With the rise of the formally organised accountancy profession, with key
developments in the latter half of the 19th century, and the associated rise of
accounting in academia (especially after the Second World War), the focus
substantively shifted towards the financial and economic as these areas were
confirmed as of importance and mainstream. This has been reflected in
generally accepted accounting principles and the accounting standards that
have become so influential since the early 1970s (particularly following the
scandals of financial accounting representation of the late 1960s).
The basic emphasis on accounting as an instrument for economic decision-
making and control has become more sophisticated but it has long been
emphasised in what we might think of as basic conventional economistic
terms.
Accounting policy-makers of influential accounting standard setting bodies
such as the US Financial Accounting Standards Board (FASB) and the
International Accounting Standards Board (IASB) have for some time
placed emphasis on the notion that financial accounting information
should guide economic decisions (in some way) and thus enhance social
welfare. In turn, the view that the quality of the financial accounting
information should be improved in this regard has been manifest with
the IASB and its predecessor (the IASC). This, then, is the basis of the
IASB’s prescriptive or normative accounting theory, which is reflected
in the IASB’s conceptual framework. In recent times, the IASB has
come to emphasise the information needs of investors rather than other
stakeholders (the position in earlier frameworks has been more expansive
– see Gallhofer and Haslam, 2007). A generous interpretation of this
emphasis might be that the IASB understands that serving investor needs
is the best way accounting information can contribute to social well-being.
AC3193 Accounting theory
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A trade-off has been seen in terms of relevant financial accounting
information for economic decisions and reliable information. This trade-
off has substantively influenced the texts of conceptual frameworks of the
accounting standard setters – frameworks in which the standard setters
have sought to articulate the basic purpose of financial accounting but
also the derived ‘qualitative characteristics’ of good financial accounting
that would satisfy that purpose. One way forward that might be envisaged
here is to provide both relevant and reliable information. For instance,
multi-columnar statements have been advocated, whereby current
value statements and forecasts are presented as well as the historic cost
accounting information that is deemed more reliable. This may require
educational input to overcome confusion.
A more fundamental trade-off, which gives more significance to trade-
offs such as the above one, is between costs and benefits of financial
accounting provision. In many mainstream economics views of information
(which would include accounting), issues of cost are ignored. In many
abstract models, a perfect information pool is simply taken to exist. These
issues are addressed more in the field of information economics that we
return to below. The accounting standard setters also tend to give scant
regard to the costs of providing information, at least in their frameworks
– although the IASB in 2008 (in the context of reviewing their conceptual
framework in conjunction with the US FASB) did point out in a statement
the importance of giving consideration to costs as well as benefits. Perhaps
the point about costs is not emphasised in the framework as it might involve
compromises over accounting that might help problematise notions that
accounting provides a ‘true and fair’ view. There is little reference to costs
of accounting information provision in the frameworks even if there clearly
are costs associated with this provision, and in practice, such costs are often
raised as an issue in debates about particular policies under consideration.
There has been some reference to costs in frameworks and related
documents of accountancy bodies internationally, just relatively little.
Further layers of complexity in the development of prescriptive theory
have been added by those acknowledging imperfections in real-world
economies. An assumption, for instance, that more economic transparency
is better than less is problematised further, beyond simple cost-benefit
analysis. Lipsey and Lancaster (1957) argue that in imperfect markets,
improving information such as accounting without improving aspects of
the system might even reduce social welfare. Reasons include that, in
a competitive economy, businesses need to have incentives to innovate
that might be countered if too much is made transparent (confidentiality
or secrecy has an economic value that may be relevant at the margin).
Even shareholders and investors may have an interest in not knowing
everything about a firm (although auditors, if able to keep information
confidential, might conceivably play a role). Another reason why Lipsey
and Lancaster’s view has some potential justification is that if more
information is publicly available, it may be easier for monopolistic firms
to strengthen monopolistic positions, which may negatively impact upon
social welfare (Gallhofer and Haslam, 2007). Reflecting further on these
issues, a prescriptive or normative theory of accounting regulation needs
to consider the unintended and unanticipated consequences that may
follow from requiring or forcing information out into the public realm. As
Joseph Stiglitz (a Nobel Prize winner in economics) has noted, information
in the public realm may be used for purposes other than originally
envisaged and with various consequences (see Gallhofer and Haslam).
Chapter 9: Theorising of accounting regulation I: normative/prescriptive theorising
89
Further, some researchers and commentators point to financial
accounting’s role beyond the economistic – a role in potentially
changing (for the better) the character of the socio-political, as well as
the economic, system instead of serving it (see Gallhofer and Haslam).
Clearly a different view from that of the established and mainstream
accounting policy-makers is possible. Some policy-makers who are less
influential than the mainstream ones, along with numerous commentators,
prescribe ways forward for accounting which involve it giving insights
into the social and environmental dimensions of the activities of an
institution or organisation, such as of a business organisation. In such
visions and prescriptions, narrower economistic financial accounting
is transformed towards more holistic accounting that reflects, from the
perspectives of those advocating it, all things relevant to social well-being.
Such prescriptive suggestions have had relatively little influence on the
mainstream accounting policy makers although The Corporate Report
(ASSC, 1975), a draft policy statement of the UK Accounting Standards
Steering Committee or ASSC (a forerunner of today’s UK Accounting
Standards Board), did put forward a more holistic stakeholder-orientated
proposal for external accounting (it never became a standard in the
political dynamics of the latter half of the 1970s in the UK).
9.4 Some regulatory implications
Perspectives assuming the existence of perfect information in perfect
and complete markets would not see the need for further regulation
from an economic perspective. In a less abstract and more realistic view,
recognising the imperfections opens up the need to consider the case
for state and/or quasi-state regulation even within a mainstream
economics perspective.
Some hold that the functioning of imperfect markets (within a basically
sound institutional framework) is enough to regulate financial accounting
adequately. This is the so-called ‘free-market’ approach to accounting
regulation. As an abstract concept or construct, it is something of an
impossible project. Any proposal that one should get rid of all state
regulations (all state laws) and ‘leave things to the market place’ should
be properly treated with suspicion. In such a vision, the market would
have to function without any legal foundation – which seems very unlikely.
Socio-economic perspectives (e.g. the theoretical perspective of Streeck
and Schmitter, see Gallhofer and Haslam, 2007) theorise regulation at the
interface of a triad of forces: the state, the market and ‘other’ forces
(sometimes labelled ‘community’ or ‘civil society’, including professional
expert associations). This triad of forces are understood as always being
present in some form but with relative degrees of difference and emphasis.
A ‘free-market’ approach is therefore advocating a regulatory system in
which all forces other than the market, and more especially the forces of
the state and its laws, are minimised in significance – especially regarding
accounting and its regulation.
The view that a free-market approach is enough has some support in the
literature, even if it is not the dominant or majority view. This support is
because businesses have economistic incentives to provide accounting
information to the market to raise equity and debt capital and an interest
in providing honest, good-quality information due to the negative impact
of loss of reputation. Following Akerlof (1970) and his analogy of the
second-hand car market, organisations failing to inform or misleading
the capital market will be regarded as ‘lemons’ and punished – there will
AC3193 Accounting theory
90
even be an incentive to disclose bad news as, in the case of non-disclosure,
investors will tend to fear something even worse; the point has some
empirical support from Skinner (1994).
Managers have strong incentives to disclose information – for
example, they may need to raise finance in a competitive marketplace
and thus provide relevant information to aid them in this (and reputation
has a value, so honesty may pay). They may have incentives to contract
with financiers to reduce their cost of capital further (especially where the
interests of shareholders and managers are more substantively aligned);
this would entail quality accounting disclosure (as this would be implied
by the contracts) and hence implicate a form of more privately driven
accounting regulation (see Watts and Zimmerman, 1978, 1986) – or even
an independent and expert audit. Further, there is a market for managers.
Managers themselves (unless, perhaps, approaching retirement) would
want to inform the market as to how well they are doing, hence improving
their own marketability. There is also the threat of takeover (the market
for corporate takeovers), which provides another incentive for managers
to do well in conventional economic terms and to honestly disclose this.
The free-market camp would thus argue that, even given real-world
imperfections, we should leave it to the market or what some call ‘market
regulation’ (noting here that markets themselves require some sort of state
regulation in practice). They would argue that the market for information
is good enough to produce an optimal or near optimal supply.
Further, regulation beyond emphasising market forces may displace
some of the positives of market functioning as, in these circumstances,
restricting choice would have some negative impacts. Interventionist
regulation may problematically restrict the accounting methods that may
be used in practice so that these become crudely uniform and not fit for
purpose (e.g. in terms of contracting) – this may also reflect a poor form
or type of interventionist regulation. Also, more users may overstate their
desire for disclosure if they do not have to pay for it directly (even if
indirectly they may bear the costs). Costs will be borne by those supplying
the information as well as, indirectly, society more generally.
History does indicate that companies will ‘voluntarily’ disclose at
least some information; Morris (1984) provides some historical evidence
of voluntary audits (although non-state pressures may play a role). But,
substantively, research points to weak financial and external accounting
in the absence of more formal state regulation. There are arguments that
legislation in this area may lull users of accounting into a false sense of
security (see Myddelton, 2004).
A view supporting a more interventionist regulation of accounting is
that the market for information is such that without interventionist
regulation, a suboptimal amount of information will be produced and the
comparability it facilitates may be less than desirable. At the same time,
contexts vary and a great deal of pressure may be placed on business in
some circumstances (e.g. by competitive forces and a strong civil society)
without legislation or quasi-law.
In relation to the contracting arguments, the actual cost of enforcing the
individual contracts or ‘group contracts’ may be higher than those costs
associated with state and/or state-like regulation. There is an interesting
question here about how the contracts would enhance the comparability
of accounting reports. In the presence of a multitude of contracting or
potentially contracting parties, the argument that private incentives will
lead to optimal accounts of accounting information seems to break down.
Chapter 9: Theorising of accounting regulation I: normative/prescriptive theorising
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In many cases, there would be too many parties and the process would be
costly. Negotiating a single contract with all investors and other financing
groups might be possible but not straightforward (Scott, 2003).
A number of related arguments have been made for regulating accounting
in an imperfect markets context.
Left unregulated by the state and similar forces, market forces may lead
to an uneven possession of information among investors. Some have more
power than others over others in relation to accounting information. It
appears fair that the less informed be protected from the more informed
and regulation may here provide an equitable solution.
Accounting information shares the characteristic of a public good and
therefore suffers from the same issues of externalities and free riders
(once available, people can use the information without paying and pass
the information on to others). Under these conditions, the absence of
interventionist regulation could result in the under-provision of information.
The actual demand for accounting information is likely to be understated
and there is then a lack of incentive to produce the information (Cooper
and Keim, 1983). And so, regulation is needed to reduce the impacts
of a market failure (Demski and Feltham, 1976; Beaver, 1981). There is,
however, a need to be careful here: an interventionist regulatory correction
may in these theoretical terms lead to over-production of accounting
information (non-users would pay for production of the good/service
without benefiting from its consumption, at least not directly).
Those favouring an interventionist approach, to some extent, embrace
tenets of a public interest theory of accounting regulation (Deegan and
Unerman, 2011). This suggests that the state, and by implication other
social actors, can actually act in the public interest (in terms of intention).
Some doubt this and take the pessimistic view that even regulators see an
interest in the regulation that is more in the nature of a private (usually
economic) interest (e.g. an interest in maintaining and enhancing their
roles). This is a pessimistic view as it may lead to the conclusion of
no hope for a public interest approach or the conclusion that the best
regulatory policy is the one that disperses power as much as possible, as
people with power use it badly from a social point of view. Perhaps what is
needed is a more pragmatic approach that sees positives and negatives in
a variety of regulatory approaches and that tries to prescribe and operate
in the contours of what is possible with a view to better realising the best
possible impact in pragmatic terms (see Gallhofer and Haslam, 2017,
for some relevant thoughts on this in relation to a form of accounting
prescription).
In the current context, some of the pessimists hold that even where the
regulators have good intentions, they are likely to be captured by the
powerful interests (especially the more powerful) who are the intended
regulated (in descriptive or positive theoretical terms this is ‘capture
theory’, see Deegan and Unerman, 2011). These powerful interests may
even include the larger accounting firms (see Walker, 1987). Interestingly,
it has been argued that the IASB itself has something of an aversion to
overly strong forms of accounting regulation.
The ‘level playing field argument’, which has been the basis of laws
prohibiting insider trading, has also been made to support state or quasi-
state accounting regulation. This argument may also be made from an
industry perspective – acceptable imposed standards might displace
competitive pressures that might more effectively engender disclosure, for
instance (although, in practice, businesses and industry associations tend
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to caution against disclosure prescription in general). But deciding on the
particular content and level of the state or quasi-state regulation is far
from straightforward.
Further, managers have incentives not to disclose unfavourable
information. Consequently, investors would be unable, in the absence of
the interventionist regulation envisaged, to distinguish good companies
from bad ones, resulting in adverse forms of selection. Investors need to
be protected from the fraudulent and, due to information asymmetries,
disclosures may not obviously be seen as fraudulent.
Some argue that markets are not so speedy in re-adjusting to changes.
Even if markets do keep returning to reasonable positions or an
equilibrium (a contestable view), people may get hurt in the process,
given the slow speed. Indeed, this may be in ways they can scarcely be
compensated for.
The above argumentation suggests that in an imperfect markets context,
there is a need to carefully reflect upon the content and level of disclosure
or transparency. It has been suggested that a degree of secrecy or
confidentiality is required to allow the system to better function (e.g. to
create incentives for research and development and discourage monopolistic
practice that might be encouraged through information sharing).
The recognition that accounting regulation brings costs (for instance,
Hakansson, 1977, argues that costs are imposed where standards reveal
proprietary information to competitors) as well as benefits needs to be
treated very carefully. The notion of balancing costs against benefits
threatens notions of accounting as a true and fair representation (as
Deegan and Unerman, 2011, note) but clearly this calls for education
about the nature of accounting in practical reality (see Collett, 1995).
Some analysts of the issues have used game theory as a framework and
tried to model (appreciating the possibility of audit) external financial
accounting disclosures in relation to the incentives of regulators and
corporate managers (e.g. incentives to disclose or hide, to be honest or
dishonest). Dimensions of uncertainty and the costliness of information
can be built into this modelling. An incentive is to seek to answer
questions such as: Is a rigid regulatory system better than a more flexible
one? Is mandatory disclosure better than a looser more voluntary
approach? This framework can enhance appreciation of the character
and feasibility of actual and potential regulatory forms; although it is not
straightforward to translate this into social welfare implications in an
imperfect markets and imperfect societal context.
More radical views of accounting regulation are found in the literature,
even beyond the regulation of accounting that is more holistic in its
character. Some prescribe a total system change to a very different kind
of society in which a new accounting and a new kind of accounting
regulation would hold sway. For the moment, such advocates conclude
that the best current regulation of accounting would be that which would
contribute to the systems change (see Tinker, 1985; Spence, 2009).
Activity 9.2
An economist argues that accounting should not be regulated.
Seek to clarify, and to challenge, the economist’s position – make relevant notes.
Chapter 9: Theorising of accounting regulation I: normative/prescriptive theorising
93
9.5 Overview of chapter
In this chapter, we have given an overview of accounting regulation in
terms of its meaning and in terms of giving more emphasis to normative
(prescriptive) theoretical approaches. We examined the theories behind
the arguments for more and less accounting regulation.
9.6 Reminder of learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• explain and discuss various dimensions of accounting regulation
• critically evaluate existing normative/prescriptive theory of accounting
regulation
• begin to articulate a theoretical position on accounting regulation.
9.7 Test your knowledge and understanding
1. Drawing from analytical reasoning in economics, what are the
arguments for and against regulation?
2. Outline theories of accounting regulation that emphasise normative
(prescriptive) theory and go beyond the more economistic theorising.
9.8 Sample examination questions
9.1 Outline arguments that have been put forward in respect of the
regulation of accounting. What do you see as the way forward for
accounting regulation?
9.2 Compare and contrast different approaches to accounting regulation.
9.3 Is a public interest theory of accounting regulation meaningful?
Notes
AC3193 Accounting theory
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Chapter 10: Theorising of accounting regulation II: positive/descriptive theorising
95
Chapter 10: Theorising of accounting
regulation II: positive/descriptive
theorising
10.1 Introduction
In this chapter we turn our attention to positive/descriptive theorising of
accounting regulation. We look at a variety of approaches informed by
various kinds of empirical research.
10.1.1 Aims of the chapter
The aims of this chapter are to:
• elaborate upon and discuss the regulation of accounting, focusing
upon positive/descriptive theorising of accounting regulation
• expand on the theorising of accounting regulation, with reference to
types of theory already introduced
• discuss both positive/descriptive theorising of accounting regulation
that has worked with an economistic lens, and positive/descriptive
theorising that has worked with a lens beyond the economistic (such
as the social, socio-political and cultural).
10.1.2 Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• explain and discuss various dimensions of accounting regulation
• critically evaluate positive/descriptive theorising of accounting
regulation (covering theorising with both economistic and extra-
economistic reference)
• articulate a theoretical position on accounting regulation.
10.1.3 Essential reading
Baudot, L. and K. Robson ‘Regulation’ in Roslender, R. (ed.) The Routledge
companion to critical accounting. (London: Routledge, 2018) [ISBN
9781317686736].
Deegan, C. and J. Unerman Financial accounting theory. (Maidenhead:
McGraw-Hill Education, 2011) 2nd edition [ISBN 9780077126735].
Chapter 3.
10.1.4 Further reading
Gallhofer, S. and J. Haslam ‘Exploring social, political and economic
dimensions of accounting in the global context: the IASB and accounting
disaggregation’, Socio-Economic Review 8(4) 2007, pp.633–64.
Tinker, T. Paper prophets: a social critique of accounting. (London: Holt, Rinehart
and Winston, 1985) [ISBN 9780039106416].
10.1.5 References cited
Annisette, M. ‘The true nature of the World Bank’, Critical Perspectives on
Accounting 15(3) 2004, pp.303–23.
Annisette, M. ‘People and periods untouched by accounting history: an ancient
Yoruba practice’, Accounting History 11(4) 2006, pp.399–417.
Annisette, M. and D. Neu ‘Accounting and empire: an introduction’, Critical
Perspectives on Accounting 15(1) 2004, pp.1–4.
AC3193 Accounting theory
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Arnold, P.J. ‘Institutional perspectives on the internationalization of accounting’,
in Chapman, C.S., D.J. Cooper and P. Miller (eds) Accounting, organizations
and institutions: essays in honour of Anthony Hopwood. (Oxford: Oxford
University Press, 2009)
Arnold, P.J. and P. Sikka ‘Globalization and the state–profession relationship:
the case of the Bank of Credit and Commerce International’, Accounting,
Organizations and Society 26(6) 2001, pp.475–79.
Arnold, P.J. ‘Disciplining domestic regulation: the World Trade Organization
and the market for professional services’, Accounting, Organizations and
Society 30(4) 2005, pp.299–330.
Arnold, P.J. ‘The political economy of financial harmonization: the East
Asian financial crisis and the rise of international accounting standards’,
Accounting, Organizations and Society 37(6) 2012, pp.361–81.
Botzem, S. The politics of accounting regulation: organizing transnational
standard setting in financial reporting. (Cheltenham: Edward Elgar, 2012)
[ISBN 9781783475841]
Broadbent, J. and R. Laughlin Accounting control and controlling accounting:
interdisciplinary and critical perspectives. (Emerald: Bingley, Yorkshire, 2013)
[ISBN: 9781781907634]
Burchell, S., C. Clubb and A.G. Hopwood ‘Accounting in its social context:
towards a history of value added in the United Kingdom’, Accounting,
Organizations and Society 10(2) 1985, pp.381–413.
Caraminis, C.V. ‘The interplay between professional groups, the state and
supranational agents: Pax Americana in the age of “globalization”’,
Accounting, Organizations and Society 27(4–5) 2002, pp.379–408.
Chand, P. and M. White ‘A critique of the influence of globalization and
convergence of accounting standards in Fiji’, Critical Perspectives on
Accounting 18(5) 2007, pp.605–22.
Chua, W.F. and S.L. Taylor ‘The rise and rise of IFRS: An examination of IFRS
diffusion’, Journal of Accounting and Public Policy 27(6) 2008, pp.462–73.
Cooper, D.J. and M.J. Sherer ‘The value of corporate accounting reports:
arguments for a political economy of accounting’, Accounting, Organizations
and Society 9(3–4) 1984, pp.207–32.
Danjou, P. and P. Walton ‘The legitimacy of the IASB’, Accounting in Europe 9(1)
2012, pp.1–15.
DiMaggio, P.J. and W.W. Powell ‘The iron cage revisited: institutional
isomorphism and collective rationality in organizational fields’, American
Sociological Review 48(2) 1983, pp.147–60.
Erb, C. and C. Pelger ‘“Twisting words?” A study of the construction and
reconstruction of reliability in financial reporting standard-setting’,
Accounting, Organizations and Society 40 2015, pp.13–40.
Graham, C. and D. Neu ‘Accounting for globalization’, Accounting Forum 27(4)
2003, pp.449–65.
Hallström, K.T. Organizing international standardization – ISO and the IASC in
question of authority. (Cheltenham: Edward Elgar, 2004).
Hope, T. and R. Gray ‘Power and policy-making: the development of an R&D
Standard’, Journal of Business Finance and Accounting 9(4) 1982, pp.531–58.
Mennicken, A. ‘Connecting worlds: the translation of international auditing
standards into post-Soviet audit practice’, Accounting, Organizations and
Society 33(4–5) 2008, pp.384–14.
Meyer, J.W. ‘The world polity and the authority of the nation-state’, in
Bergesen, A. (ed.) Studies of the modern world-system. (New York, NY:
Academic Press, (1980).
Meyer, J.W., J. Boli, G.M. Thomas and F.O. Ramirez ‘World society and the
nation state’, American Journal of Sociology 103(1) 1997, pp.144–81.
Müller, J. ‘An accounting revolution? The financialization of standard setting’,
Critical Perspectives on Accounting 25(7) 2014, pp.539–57.
Neu, D., A.S. Rahaman, J. Everett and A. Akindayomi ‘The sign value of
accounting: IMF structural adjustment programs and African banking
reform’, Critical Perspectives on Accounting, 21(5) 2010, pp.402–19.
Chapter 10: Theorising of accounting regulation II: positive/descriptive theorising
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Power, M. ‘Financial accounting without a state’, in Chapman, C.S., D.J. Cooper
and P. Miller (eds) Accounting, organizations and institutions: essays in
honour of Anthony Hopwood. (Oxford: Oxford University Press, 2009) [ISBN
9781843764816].
Power, M. ‘Fair value accounting, financial economics and the transformation of
reliability’, Accounting and Business Research 40(3) 2010, pp.197–210.
Puxty, A.G., H.C. Willmott, D.J. Cooper and T. Lowe ‘Modes of regulation in
advanced capitalism: locating accountancy in four countries’, Accounting,
Organizations and Society 12(3) 1987, pp.273–91.
Ravenscroft, S. and P.F. Williams ‘Making imaginary worlds real: the case of
expensing employee stock options’, Accounting, Organizations and Society
34(6–7) 2009, pp.770–86.
Richardson, A. ‘Regulatory networks for accounting and auditing standards: a
social network analysis of Canadian and international standards setting’,
Accounting, Organizations and Society 34(5) 2009, pp.571–88.
Robson, K. and J. Young ‘Socio-political studies of financial reporting and
standard setting’, in Chapman, C.S., D.J. Cooper and P. Miller (eds)
Accounting, organizations and institutions: essays in honour of Anthony
Hopwood. (Oxford: Oxford University Press, 2009) [ISBN 9781843764816].
Suddaby, R., D.J. Cooper and R. Greenwood ‘Transnational regulation of
professional services: governance dynamics of field level organizational
change’, Accounting, Organizations and Society 32(4–5) 2007, pp.333–62.
Walker, R.G. ‘Australia’s ASRB: A case study of political activity and regulatory
capture’, Accounting and Business Research 17(67) 1987, pp.269–86.
Walters, M. and J.J. Young ‘Metaphors and accounting for stock options’,
Critical Perspectives on Accounting 19(5) 2008, pp.805–33.
Watts, R.L. and J.L. Zimmerman Positive accounting theory. (Englewood Cliffs,
NJ: Prentice-Hall, 1986) [ISBN 9780136861713].
Willmott, H.C., A.G. Puxty, K. Robson, D.J. Cooper and E.A. Lowe ‘Regulation
of accountancy and accountants: a comparative analysis of accounting
for research and development in four advanced capitalist countries’,
Accounting, Auditing and Accountability Journal 5(2) 1992, pp.31–54.
Young, J.J. ‘Outlining regulatory space: agenda issues and the FASB’,
Accounting, Organizations and Society 19(1) 1994, pp.83–109.
Young, J.J. ‘Making up users’, Accounting, Organizations and Society 31(6)
2006, pp.579–600.
Zhang, Y., J. Andrew and K. Rudkin ‘Accounting as an instrument of
neoliberalisation? Exploring the adoption of fair value accounting in China’,
Accounting, Auditing and Accountability Journal 25(8) 2012, pp.1266–89.
Zhang, Y. and J. Andrew ‘Financialisation and the conceptual framework’,
Critical Perspectives on Accounting 25(1) 2014, pp.17–26.
10.2 Positive/descriptive theorising of accounting
regulation that has emphasised the economistic
Our overview of positive and descriptive theorising of accounting
regulation draws upon:
• Deegan and Unerman (2011), who focus much on capture theory in
their chapter on accounting regulation
• Baudot and Robson (2018), who focus on research that, as they
point out, draws upon political-economic, institutional, cultural and
discursive constructionist frameworks.
The economic reasoning that has been mobilised in relation to prescriptive
or normative theorising of accounting regulation has parallels in practice.
For instance, the identification in reasoning with a more economistic-
analytical emphasis of costs as an issue in deciding upon accounting
regulation has been indicated in practice. Many industry lobbyists, for
instance, concerned to raise issues about proposed accounting prescription
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under accounting regulation, cite various costs such as the costs of
compliance (Gallhofer and Haslam, 2007).
Factors such as information costliness and the imperfect markets context,
together with principal–agency issues (lack of shareholder control over
corporate management), may explain why many commentators believe
that financial accounting in practice falls short of providing the quality
information that one might assume capital providers would want (Tinker,
1985, refers to ‘shareholder alienation’ in this regard).
Another view that has been articulated by Joseph Stiglitz – the Nobel
Prize winner in economics who is especially well versed in the field of
information economics – builds further upon the notion of context
imperfection. He moves towards appreciating the more general
imperfect character of the socio-economic and political context; in his
argumentation, he offers a more interdisciplinary perspective upon
accounting, indicating that financial accounting cannot be understood to
have only narrowly conceived economic consequences. Stiglitz notes
that when information like financial accounting enters the public realm,
it enters a complex context of conflicting forces. We cannot assume in
this context that information produced for Purpose X (providing relevant
information for presumed investor decision-making needs – presumed
because some have noted that investors are often interested in making
ethical decisions beyond the narrow financial interests they are presumed
to have) will not also be used for another purpose, say Purpose Y. Purpose
Y could include, for instance, the desire to impose stricter regulations on
business and/or enhance the general democratic control over business.
Gallhofer and Haslam (2007) provide some empirical evidence to support
this type of unanticipated outcome of an accounting regulatory move as an
aside from the main thrust of their project.
Deegan and Unerman (2011) elaborate upon potential evidence of capture
theory (Chapter 9) in relation to accounting regulation. They suggest that
the greater the industry’s total resources relative to regulator resources,
the greater the chance of capture. They cite some evidence suggesting that
the larger accountancy firms have a degree of capture over accounting
regulation (Walker, 1987; Deegan and Unerman, 2011).
Deegan and Unerman (2011) note that there is much evidence that points
to accounting regulation having real social and economic consequences
for many organisations and people, so that such consequences cannot
be ignored in more prescriptive or normative approaches. They discuss
concerns expressed over share options in accounting as covered by IFRS
(International Financial Reporting Standard) 2. IFRS 2 introduced the
policy whereby the fair value of share options now has to be recognised as
an expense in the income statement. It was argued that this would make
some companies less likely to use share options, which might demotivate
executives to some extent, leading to poorer economic performance.
Another case cited by Deegan and Unerman is that of the implementation
of a new UK accounting standard on pension liabilities in the early 2000s.
This new standard introduced substantial volatility into the accounting
measurement of pension fund assets and liabilities for defined benefit
pension schemes. It is argued that this may have contributed to some
decisions made by employers to close final salary type schemes.
In some cases, lobbying by industry over accounting regulation appears to
have been successful from the industry viewpoint. Hope and Gray (1982)
concluded this in relation to proposed accounting standardisation in the
area of research and development. The same conclusion can be made with
regard to the lobbying by European banks against the volatility-enhancing
Chapter 10: Theorising of accounting regulation II: positive/descriptive theorising
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provisions of IAS 39 (which was eventually superseded by IFRS 9) (see
Deegan and Unerman, 2011). Some lobbying for politically sensitive
industries appears to have sought to reduce accounting profit, while much
other reported lobbying has the opposite sort of aim.
Broadbent and Laughlin’s research on lobbying in the UK surrounding
the development of accounting regulations applicable to government
accounting for projects involving the private sector provision of public
services (known as PFI projects or public private partnerships) is interesting.
They found that various regulatory bodies adopted positions which could
be interpreted as seeking to defend or enhance their standing with groups
appointing them and giving them legitimacy. These positions were driven
by factors beyond conventional economics. (see Broadbent and Laughlin,
2013).
10.3 Accounting regulation from a political economy
perspective
Accounting regulation has been studied from a political economy
perspective where the key question is: who benefits given the structuring
of society (e.g. the capitalistic character of that society) and its key
ideological currents (e.g. the encouragement of capitalistic instrumentality
and financialisation)? (See Cooper and Sherer, 1984; Arnold and Sikka,
2001; Arnold, 2005, 2012.) Such works have pointed to the gains from the
system or context attained by the powerful economic interests involved
(see Cooper and Sherer, 1984; Tinker, 1985; Baudot and Robson, 2018).
Accounting regulation has, related to this, been viewed with an
appreciation of power in a global and geo-political context, where world
empires and core economies (as Baudot and Robson, 2018, put it) exploit
nation states and economic regions at the periphery, including through
mobilising ideologies and rhetoric (see Arnold, 2009).
The socio-institutional analysis of Gallhofer and Haslam (2007) also
seeks to identify which groups have an interest in accounting regulation
in practice and then to explore manifestations of interested behaviour
in relation to the history of the IASC/IASB. Studies of the particular
backgrounds of IASC/IASB actors reflect ideological commitments aligned
to user needs and financial instruments (see Gallhofer and Haslam,
2007; Botzem, 2012). Studies have pointed to a government by experts
(e.g. Power, 2009) but these are experts with particular ideological
commitments. Some have emphasised the profession’s own power plays
in the international arena. Arnold and Sikka (2001) indicate that the
regulatory capacity of non-governmental (private) global institutions such
as the accounting profession has been growing; Chua and Taylor suggest
that the IASB is engaged in rhetorical strategies with this type of outcome
in mind (see also Caraminis, 2002; Suddaby et al., 2007). The transfer of
sovereignty to non-governmental organisations is highlighted in a number
of studies (see Chua and Taylor, 2008; Danjou and Walton, 2012).
While these types of study have more obvious critical dimensions (with
the aim of exploring vested interests and agenda-setting in relation to
accounting regulation), other interdisciplinary studies also have critical
dimensions, as Baudot and Robson (2018) correctly point out. Studies
show, for instance, dispersed sites of accounting regulation, discourses
and programmes underlying regulatory initiatives (such as the influential
case of neo-liberalism) and the growing rationalisation of accounting and
auditing practices (these indicating and entailing, for Baudot and Cooper,
2018, critical insights and concerns). Burchell et al. (1985) offered a
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key contribution in the latter respect; accounting regulation is seen to be
constructed in a way that is contingent upon the particular constellation
of organisations, processes, models and ideas present in the various arenas
of import in any given context or period of time. The researchers therefore
seek to unravel a problematisation of taken-for-granted programmes,
issues and rationalities of accounting regulation, as well as the links to
discourses surrounding such programmes, issues and rationalities (see
Robson and Young, 2009; Baudot and Robson, 2018).
Activity 10.1
Read Deegan and Unerman (2011) on capture theory. Reflect upon this in relation to
Gallhofer and Haslam (2017) (referenced in Chapter 9).
Summarise the Deegan and Unerman (2011) view. Do you think capture theory as
presented by Deegan and Unerman is a one-sided position?
10.4 Cultural and institutional ways of seeing accounting
regulation
Cultural and institutional dimensions are given more emphasis in some
studies. Postcolonial studies of accounting regulation, for instance, give
attention to the roles, experiences and perspectives of the peripheral and
trace out forces of resistance (which have tended to be relatively weak) from
anti-capitalist and anti-hegemonic non-governmental organisations (see
Graham and Neu, 2003; Annisette, 2004, 2006; Annisette and Neu, 2004;
Rahaman et al., 2007; Neu et al., 2010; see Baudot and Robson, 2018).
Meyer (1980) and Meyer et al. (1997) emphasise the development of
cultural convergence on a global scale. The convergence is understood
as being transmitted by a ‘world polity’, whereby global actors are
interconnected, with cultural systems and dimensions embedded in
Western societies. As Baudot and Robson (2018) point out, the theorising
here parallels the institutional theory of DiMaggio and Powell (1983).
Institutional theory has itself been called upon and used in theorising
accounting regulation. It has articulated critical dimensions (see
Chapter 8 of this guide) through drawing upon themes of regulatory
and normative diffusion and isomorphism. For example, there has been
research showing that the growth and spread of regulatory agencies in
accounting has indicated an isomorphism that has an interest in building
legitimate authority (Tamm-Hallstrom, 2004), reflecting core concerns of
institutional theoretic approaches.
From a more constructionist perspective that helps highlight the conditions
of possibility and regulatory spaces, there has been a concern to explore
how wider practices surrounding accounting flow into it and help
reconstruct accounting’s role and mission (see Young, 1994). Much of the
emphasis of such research has been upon the discursive or programmatic
components shaping changes in accounting regulation – Baudot and
Robson (2018) suggest that one such component is ‘transparency’.
10.5 Ideologies and rhetoric of accounting regulation
Ravenscroft and Williams (2009) have delineated how the information-
usefulness objective of financial statements, articulated as a principle
of economics and increasingly promoted (explicitly so by mainstream
accounting standard-setting bodies such as the US FASB and the IASB),
has acted as a naturalising instrument for a neo-liberal ideology that has
Chapter 10: Theorising of accounting regulation II: positive/descriptive theorising
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displaced more traditional accountability objectives. This process, also
articulated in different ways and with different emphases in Young (2006),
Gallhofer and Haslam (2007), Power (2010), Zhang et al. (2012), Müller
(2014), Zhang and Andrew (2014) and Erb and Pelger (2015), may be
best articulated in terms of a process of intensification rather than as
one of absolute or dramatic change. The studies reflect similar concerns
of those of Hines in her earlier constructionist studies of accounting,
including a constructionist study of the conceptual framework of the US.
Manifestations of accounting approved in regulatory processes and
dimensions of these manifestations have been seen as having a role in
enabling processes of economic liberalisation; for example, in relation to
possibilities for professional services and audit firms, as in the study of
Arnold (2005). Such explorations of the programmatic ideals of regulatory
agencies (including non-governmental organisations such as the IASB)
have shown commonalities between the adoption of ‘user-decision’ and
‘value-relevant’ (see Watts and Zimmerman, 1986) rationales for building
up regulatory standards (Young, 1996; Power, 2010).
Walters and Young (2008) is an interesting study that brings out the
value of rhetoric in revealing or suppressing the underlying construction
of accounting issues and possible solutions (a study that may be taken as
having been influenced by the study of Burchell et al., 1985, which Baudot
and Robson, 2018, acknowledge).
10.6 Studying the interface between the global and
national
Studies theorising accounting regulation in positive and descriptive terms
have done so in relation to cross-national differences (including
cultural and institutionally embedded factors with some historical
appreciation) and with regard to processes ostensibly concerned with
accounting harmonisation more globally.
Overall, there are some interesting differences in findings. In this regard,
it is of note that some researchers, including Puxty et al. (1987), have
found cross-national differences to mediate accounting regulation in such
a way as to encourage substantive scepticism about the prospects for
convergence or harmonisation in the accounting sphere globally – while
other researchers, including Willmott et al. (1992), have found cross-
national differences to mediate accounting regulation so as to encourage
more confidence about the prospects for convergence and harmonisation.
In many studies (including both Puxty et al., 1987, and Willmott et al.,
1992), there is some acknowledgment that at the level of nation states
and economic regions, as well as at the level of bodies that are ostensibly
global institutions, there are forces that are influential in the processes of
accounting regulation. While many studies thus point to the continuing
influence of nation states and regional economies, more especially in
relation to local spheres, it is a key finding that the global or international
bodies or associations have substantial influence in accounting regulation.
Mennicken (2008) advocates that researchers explore the detail of how
global standards are laid out in local settings and how these settings
convert the local back to the global. She illustrates the value of such a
framing in her study of auditing in Russia (Mennicken, 2008).
Chand and White (2007) explore the willingness of a developing country
with a limited capital market (Fiji) to accept international accounting
standards. The analysis of Chand and White (2007) points to the substantial
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influence of international accounting firms in Fiji, a country that is relatively
poor in terms of not having many resources to develop its own accounting
standards. Thus, the international accounting standards are accepted
even if their practical applicability (especially given the promotion in the
framework and standards of the construct of ‘fair value’) in the Fijian
context is doubted by Chand and White (2007). In different ways, the case
of China also illustrates the difficulties of implementing harmonisation and
convergence once this agreed (see Baudot and Robson, 2018).
The extensive network analysis of Richardson (2009), which Baudot and
Robson (2018) cite as a rare study of its kind, illustrates again both the
local and global influences upon accounting regulation in the context of
Canada.
As Baudot and Robson (2018) conclude, a lot more research can be done
to increase our understanding of accounting regulation through what
we have labelled here positive and descriptive theorising of accounting
regulation.
Activity 10.2
Summarise research with which you are familiar on the ideology and rhetoric of
accounting regulation. To what extent can Gallhofer and Haslam (2007) be considered
such a study?
10.7 Overview of chapter
We have given an overview of accounting regulation theory focusing on
that theory that has emphasised the positive/descriptive theory-building
approach (in terms of the distinction made in Chapter 2 of this guide).
10.8 Reminder of learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• explain and discuss various dimensions of accounting regulation
• critically evaluate positive/descriptive theorising of accounting
regulation (covering theorising with both economistic and extra-
economistic reference)
• articulate a theoretical position on accounting regulation.
10.9 Test your knowledge and understanding
1. What is meant by the political economy of accounting regulation?
2. ‘Empirical studies on accounting regulation have broadly had two
focuses – the social and the economic.’ Is this a reasonable view?
10.10 Sample examination questions
10.1 Discuss different theories that have been put forward to describe how
accounting is regulated in society. You can share your thoughts with other
students on the VLE.
10.2 What do you understand by ‘capture theory’? Can you illustrate
examples of capture theory from the real-world attempts to regulate
accounting?
Part 2: Management accounting
103
Part 2: Management accounting
Introduction
Welcome to the management accounting section of AC3193
Accounting theory.
In this section (Chapters 11–20), we will look in detail at management
control. The section considers why and how organisations control and
measure their activities. It takes a broad approach which could be useful
for all management personnel. For students of management accounting, it
broadens understanding of the whole control and measurement function.
This will enable you as management accountants to be a more effective
part of the management team, linking your deep knowledge of accounting
with a good understanding of how financial results and reports are used
within the organisation and how they can be made more effective in
enabling managers to pursue organisational targets.
Organising your studies
In Chapters 11–20 of the subject guide, the topics are organised based
on the chapters of the textbook listed below. The textbook is very
comprehensive, citing many sources giving different viewpoints and
examples. Due to its comprehensive nature, for most chapters, there are
few further readings.
The subject guide topics are based around the contents of each textbook
chapter and are aimed at giving you a summary of the main themes with
activities guiding you towards issues which may be amplified in the text.
There are some suggestions of using web-based examples.
The end of each chapter gives a case study from the textbook with
suggested questions to direct discussion. The case studies are used to help
the topics come alive. However, the examination paper will require essay
questions to be answered.
Essential reading
The reading for this course is divided into two categories: Essential and
Further. You should purchase the textbooks in the Essential reading
list below; you will also be given online access to the other essential
publications (individual book chapters, journal articles, etc.) either via the
Online Library or through scans uploaded to the VLE. You are not required
to have access to, or or to buy, the Further readings, but they may prove
helpful to you in your study.
For Chapters 11–20, the Essential reading is:
Merchant, K.A. and W.A. Van der Stede Management control systems:
Performance measurement, evaluation and incentives. (Harlow: Pearson,
2017) 4th edition [ISBN 9781292110554].
Further reading
Further reading for Chapters 11–20 is:
Chapter 11
Hammer, M. Beyond reengineering: how the process-centered organization is
changing our work and our lives. (New York, NY: Harper Business, 1996)
[ISBN 9780887307294].
AC3193 Accounting theory
104
Chapter 12
Hofstede, G. Culture’s consequences: international differences in work-
related values. (Beverley Hills, CA: SAGE Publications, 2001) [ISBN
9780803913066]
Ma, J. ‘Dear investors: letter from Jack Ma as Alibaba prepares roadshow’,
Financial Times [London, UK] 5 September 2014. Available online at www.
ft.com/content/54a53a50-353d-11e4-aa47-00144feabdc0
Petruno, T. ‘Sunrise scam throws light on incentive pay programmes’, Los
Angeles Times [Los Angeles, CA] 15 January 1996. Available online at
http://articles.latimes.com/1996-01-15/business/fi-24821_1_incentive-
pay-plans
The Economist ‘Tesco’s accounting problems not so funny’, The Economist
[London, UK] 27 September 2014. Available online at www.economist.
com/business/2014/09/27/not-so-funny
Chapter 13
Horngren, C.T., S.M. Datar and M.V. Rajan Cost accounting: a managerial
emphasis. (Harlow: Pearson Education Ltd, 2015) 15th edition [ISBN
9781292078977] Chapter 22.
Chapter 19
Association of Chartered Accountants (ACCA) ‘ACCA code of conduct and
ethics’, ACCA www.accaglobal.com/uk/en/member/standards/ethics/acca-
code-of-ethics-and-conduct.html
Birsch, D. and J.H. Fielder The Ford Pinto case: a study in applied ethics,
business and society. (Albany, NY: State University of New York Press, 1994)
[ISBN 9780791422342].
UK Government ‘Whistleblowing for employees’, GOV.UK www.gov.uk/
whistleblowing/who-to-tell-what-to-expect
Chapter 20
Moullin, M. ‘How the public sector scorecard works’, Public sector scorecard
www.publicsectorscorecard.co.uk/how-the-pss-works.html
Office for National Statistics www.ons.gov.uk
Further information
Details on the VLE, learning resources and examinations can be found in
the introduction to this guide: Chapter 1.
http://www.ft.com/content/54a53a50-353d-11e4-aa47-00144feabdc0
http://www.ft.com/content/54a53a50-353d-11e4-aa47-00144feabdc0
http://articles.latimes.com/1996-01-15/business/fi-24821_1_incentive-pay-plans
http://articles.latimes.com/1996-01-15/business/fi-24821_1_incentive-pay-plans
http://www.economist.com/business/2014/09/27/not-so-funny
http://www.economist.com/business/2014/09/27/not-so-funny
http://www.accaglobal.com/uk/en/member/standards/ethics/acca-code-of-ethics-and-conduct.html
http://www.accaglobal.com/uk/en/member/standards/ethics/acca-code-of-ethics-and-conduct.html
https://www.gov.uk/whistleblowing/who-to-tell-what-to-expect
https://www.gov.uk/whistleblowing/who-to-tell-what-to-expect
http://www.ons.gov.uk
Chapter 11: Introduction to control systems – personnel controls, cultural controls, action controls and results controls
105
Chapter 11: Introduction to control
systems – personnel controls, cultural
controls, action controls and results
controls
11.1 Introduction
In AC2097 Management accounting, which is a prerequisite for this
course, we discussed the advantages of, and problems with, using
accounting measures to appraise managerial performance. Here, we
will look in detail – from first principles – at why and how organisations
control and measure their activities and how the use of accounting results
is only part of that process.
11.1.1. Aims of the chapter
This chapter aims to:
• introduce the concept management control
• look at the various methods of control and the different ways in which
they are used by companies, depending on their needs
• consider the importance of controls
• explain the different types of control, such as action, personnel,
cultural and results controls.
11.1.2 Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• explain why an understanding of management control is important for
managers in all areas of an organisation
• describe the management process in terms of objective setting,
strategy formulation and management control
• discuss some causes of management control problems
• explain the terms: action controls, personnel controls and cultural
controls
• identify, for each of these types of control, ways in which it can be
implemented, the most appropriate conditions for its use and the
problems that should be considered
• explain results controls and describe the steps required to implement
them
• identify the conditions needed to implement effective results controls
and discuss why they are important.
11.1.3 Essential reading
Merchant, K.A. and W.A. Van der Stede Management control systems:
Performance measurement, evaluation and incentives. (Harlow: Pearson,
2017) 4th edition [ISBN 9781292110554] Chapters 1–3.
AC3193 Accounting theory
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11.1.4 Further reading
Hammer, Michael Beyond re-engineering: How the process-centred organisation is
changing our work and our lives. (New York: Harper Business, 1996) [ISBN
9780887307294].
11.2 The importance of management control
Budgets are part of the planning and control function of an organisation.
However, they are only a small part of what has to happen in order to
ensure that an organisation functions and meets its objectives.
People are involved at all stages in order for an organisation to operate. It
is people who create actions, so the objective of management control is put
in place systems that encourage desirable behaviour from employees and
guard against undesirable actions.
Activity 11.1
Examine this organisation chart for a hospital.
HOSPITAL ORGANISATION CHART
Board of Directors
Administration
department
Training Medical
departments
Support units
Finance
Personnel
Records/statistics
Maintenance
Security
Cleaning/gardening
Laundry
Purchasing/stores
Hospital library
Continuing
professional
development
General medicine
Surgery
Gynaecology
Dental
Ophthalmic
Laboratory
Imaging
Pharmacy
Physiotherapy
Endoscopy
Figure 11.1: Organisation chart.
Then imagine all the different jobs that there are in each area. Consider that each role
requires a job description and that each task has to follow a procedure to ensure it is
correctly done and mistakes are not made.
Activity 11.2
Familiarise yourself with the control process diagram below. Note that this process applies
– to a greater or lesser extent – to each job and person performing that job.
Collect information
about the role and
activities of the job
Measure progress
Communication and
co-operation
Set tasks and
goals
Allocate
responsibilities
Figure 11.2: Control process diagram.
Chapter 11: Introduction to control systems – personnel controls, cultural controls, action controls and results controls
107
The control process diagram in the above activity is circular because
processes need to be regularly reviewed to ensure that they remain
relevant.
Organisations need processes, called controls, to ensure that the
appropriate activities take place, that performance is monitored to ensure
that there are no mistakes and to improve processes. Controls fall into the
following categories: cultural, personnel, action and results.
Cultural controls are built on shared traditions, norms, beliefs, values,
ideologies, attitudes and ways of behaving which are accepted by the
group. An organisation’s culture encourages mutual monitoring and group
pressure being placed on individuals who do not follow group norms.
These controls work best where the group shares emotional ties.
Personnel controls rely on employees’ natural tendency to control and
motivate themselves. They encourage self-control, intrinsic motivation,
ethics, morality, trust and loyalty.
Action controls specifically state the actions that an employee should
take. The action is the focus of the control (e.g. sewing buttons on shirts).
Results controls are different in that they do not specify how a role
should be performed but what the outcome is expected to be.
Returning to our hospital example in Activity 11.1, a nurse working on a
ward may have the following controls:
• Cultural: training and rules on how to perform procedures laid down
by the association.
• Personnel: a motivation to do the best for patients, the team and abide
by medical ethics.
• Action: shift hours, checks on punctuality, procedures that must be
carried out for each patient at certain times, rules on filling in records
of patient treatment, etc.
• Results: promotion, maybe team-based rewards.
Activity 11.3
The following matrix gives a good indication of when these different controls may be
used. Consider the four control types and then fill in each box with the most appropriate
type.
Ability to measure results
High Low
Excellent
Poor
Knowledge of
which specific
actions are
desirable
AC3193 Accounting theory
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Feedback
The following are examples of how you might have filled in this matrix:
• high ability to measure results and high knowledge of which specific actions are
desirable – action control; e.g. a routine job such as sewing shirts
• high ability to measure results but poor knowledge of specific actions – results
control; e.g. managing a department, organising a delivery schedule
• low ability to measure results but high knowledge of specific actions – cultural control
and action control; e.g. a nurse
• low ability to measure results and poor knowledge of specific action – personnel
control; e.g. research and development laboratory.
It is important for managers in all areas of an organisation to have a
thorough understanding of management control. This relates to all the
resources that a manager might use and includes both machines and
people. Therefore every manager should understand which controls are
appropriate for their department and how they will be used.
The issues below relate to Merchant and Van der Stede (2017) Chapter 1,
which you can read either before, or in conjunction with these notes and
activities.
Activity 11.4
Answer questions 1 and 2 before you check your answers!
1. Which of the following people are not likely to be interested in the contents of the
textbook?
a. Financial specialists
b. Personnel directors
c. Sole traders
d. Auditors.
2. Each of the following describes a problem mentioned in Chapter 1 of Merchant and
Van der Stede (2017) that had occurred in organisations due to lack of management
control. Match the scenarios in (a) to (e) to the organisations in (i) to (v).
a. Students’ grades change dramatically. i) A motor manufacturer
b. An employee sends details of secret research
to the media.
ii) A bank
c. Employees shredded 90,000 documents. iii) The Bank of England
d. A company designed software to deceive
regulators.
iv) A schoolteacher
e. An employee fell asleep at the keyboard. v) A service centre working for the government.
3. Explain in your own words what happened in each scenario described in question 2.
Chapter 11: Introduction to control systems – personnel controls, cultural controls, action controls and results controls
109
Feedback
1. (c)
2.
a. (iv)
b. (iii)
c. (v)
d. (i)
e. (ii)
11.2.1 Objective setting
All organisations should be able to identify their purpose. This is
sometimes done by use of a mission statement. The following are
examples of the mission statements of different types of organisations:
Save the Children
‘Our mission is to to inspire breakthroughs in the way the world treats
children and to achieve immediate and lasting change in their lives.’
San Diego Zoo
‘San Diego Zoo Global is committed to saving species worldwide by uniting
out expertise in animal care and conservation science with our dedication
to inspiring passion for nature.’
IKEA
‘Our vision is to create a better everyday life for the many people.’
Activity 11.5
Using the internet, look up the mission statement of any organisation you are interested
in. Then ask yourself whether you think the mission statement is sufficiently clear so that
you can identify the specific activities that the organisation carries out.
Make notes of your views.
11.2.2 Strategy formulation
Strategy formulation aims to identify an organisation’s future strategy
and to define the ways in which its resources will be used to achieve its
strategic goals.
Some companies’ starting point is to identify specifically where they are
heading and plan accordingly. Others allow their strategy to emerge from
the environment and interactions between employees and management,
utilising spontaneous decisions or local experimentation. The latter is
more likely to take place in organisations where there are often influential
changes in the environment that will affect the future (e.g. research
organisations, service providers, etc.).
11.2.3 Management control
Management control comprises all the measures that are put in place to
help sustain a workforce. It includes the strategies that management use to
encourage, enable and, possibly, force employees to work in the ways the
organisation requires.
AC3193 Accounting theory
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Activity 11.6
Explain how object setting, strategy formulation and management control are related.
11.2.4 Behavioural emphasis
It is people who create actions, so the objective of management control
is to put in place systems that encourage desirable behaviour from
employees and guard against undesirable actions.
Activity 11.7
What three issues are suggested in Chapter 1 of Merchant and Van der Stede (2017) that
need to be determined for each employee?
Think about which of these issues could be relevant for an electrician working in a
maintenance department of a university. Jot down your thoughts and compare your notes
with those of other students on the VLE.
11.3 Causes of management control problems
11.3.1 Lack of direction
Employees need to know what they are expected to do and how they can
maximise their efficiency to help fulfil the objectives of the organisation
they work for. If this is not clear, employees will set their own goals, which
may not coincide with the organisation’s requirements.
11.3.2 Motivational problems
An organisation’s goals are more likely to be met if employees are
motivated to work productively.
Apart from preventing activities such as fraud, organisations need to
create a climate which deters employees from time wasting and, more
importantly, a work environment that enables people to gain satisfaction
from working hard.
Office workers who cannot really see the outcome of their work because
it is just part of a system may not be motivated to work hard consistently.
They may spend part of their time at work engaged in nonwork-related
activities like surfing the internet. Contrast this with teachers who are very
engaged and therefore spend extra time encouraging their pupils to be
enthused so that they will make progress. This is not to say that all office
workers are disengaged and all teachers are devoted, but it does highlight
the lack of satisfaction experienced when an employee does not feel
fulfilled.
11.3.3 Personal limitations
A person may not be equipped for the job they are required to do, either
because of poor recruitment or poor training. They may have been
promoted beyond their abilities. They may not have been given sufficient
information to do the job or the job may be too difficult to do in the time
allowed.
11.3.4 Characteristics of good management control
Good control is evident if management is confident that no major or
unpleasant surprises will occur. Not having perfect control (which is
impossible) is called control loss. If the control loss is high, extra measures
Chapter 11: Introduction to control systems – personnel controls, cultural controls, action controls and results controls
111
must be put in place as long as they are cost effective (i.e. implementing
the controls costs less than the potential loss).
Sometimes, more effective operations can be brought about by
significantly changing the way things are done. For example:
• Activity elimination: when a company does not have expertise in a
particular area they may consider outsourcing.
• Automation, computers, robots, expert systems, production
automation: these may be more cost effective than human staff. This
may result in the avoidance problems of inaccuracy, inconsistency
and poor motivation. However, only certain tasks can be dealt with in
this way and personnel with different skills are required to install and
operate them effectively. They bring their own control issues in terms
of correct training, reduced access to avoid improper use or fraud,
maintenance and back-up procedures in case of failure.
• Centralisation of key decisions: this occurs to ensure continuity
and oversight of important decisions (e.g. major acquisitions and
divestments of subsidiaries, significant capital expenditure and
negotiating sales contracts with important clients).
• Risk sharing: this includes insurance and undertaking joint ventures
with other companies.
Activity 11.8
Give specific examples of these activities, all of which help to create effective
management control:
• activity elimination
• automation
• centralisation
• risk sharing.
11.4 Action, personnel and cultural controls
It will be helpful if you read Chapter 3 before Chapter 2 of Merchant and
Van der Stede (2017). Chapter 3 discusses the control mechanisms that
will be in place regardless of whether results controls are also used. If you
read this chapter before Chapter 2, you will have an understanding of how
the day-to-day operations of organisations are planned, controlled and
supervised.
Chapter 2 on results controls explains how some management control
systems rely on the measurement of specific individual activity where
the tasks are not defined but the expected outcomes are agreed and, if
achieved, can be specifically rewarded.
The issues below relate to Merchant and Van der Stede (2017) Chapter 3
which you can read either before, or in conjunction with these notes and
activities.
11.4.1 Action controls
Action controls specifically state the actions an employee should take
in order to do their job properly. The action is the focus of the control
(i.e. if the employee carries out the work in the way specified, it is under
control). If the employee acts in a different way, and if it is observable,
then corrective action can be taken.
AC3193 Accounting theory
112
Activity 11.9
Describe the action controls that might be in place for someone who works on a
supermarket checkout.
Action controls may be negative (i.e. stopping an employee from
performing incorrect actions) or positive (i.e. guiding employees on how
to perform the tasks required of them).
Behavioural constraints are built in with the intention of preventing
employees from performing incorrect actions. The constraints include:
• physical (e.g. locks on cabinets, computer passwords)
• administrative rules (e.g. limiting spending authority, separation of
duties (internal control))
• Mechanical deterrents (e.g. building steps into a procedure to guard
against incorrect/dangerous actions, such as a microwave that does
not work with the door open).
If employees know the system well, they can find a way around many of
these controls.
Activity 11.10
Think through what checks or constraints may be in place at a supermarket checkout.
Preaction reviews
Action plans and budgets prepared by employees can be reviewed
by superiors. Where necessary, more details can be requested and
modifications made before approval is given.
Activity 11.11
Suggest what daily plans can be put in place to ensure that supermarket checkouts are
staffed adequately.
Action accountability
Employees can be held accountable for the actions they take. Actions
are defined as acceptable (or not) and are communicated to employees.
Employees’ activity is observed or tracked. Correct actions are praised and
may be the focus of rewards, whereas wrong actions are corrected and
may incur sanctions.
Actions are communicated either administratively through written
instructions or lists, or socially by means of colleagues modelling
acceptable behaviour.
In some areas, professional conduct is expected and, though not
necessarily clearly defined, these norms are understood by each
profession.
Communication is important. The reasons for performing actions correctly,
and the consequences of not performing them correctly, should be
communicated.
Redundancy
This involves using back-up employees or machines to create extra
resources to take over if something goes wrong. This ensures that the
process is not interrupted.
Chapter 11: Introduction to control systems – personnel controls, cultural controls, action controls and results controls
113
Prevention action controls and detection action controls
Prevention action controls ensure that employees perform correct behaviour.
This may occur through direct supervision. Detection action controls
are applied either routinely or as a result of a specific problem after the
wrong behaviour has been observed (e.g. checking mechanisms that draw
attention to the problem such as quality checks or cash reconciliations). The
existence of these checks often deters incorrect behaviour.
Conditions determining the effectiveness of action controls
• Knowledge of the desired actions – this is easy to determine in
routine procedures (e.g. a specified production activity or loan
approval decisions in banks). However, complex or uncertain tasks
(e.g. supervision, machine repairs, market research and research
engineering) are not routine and require judgement and initiative.
• Ability to ensure that the desired actions are taken – this can be tricky
in situations where employees understand the checking system that
is in place and so can circumvent it, either to hide their mistakes or
benefit from the bonus system by deliberate fraud.
11.4.2 Personnel controls
Personnel controls build on employees’ natural tendencies to control and
motivate themselves. They encourage self-control, intrinsic motivation,
ethics, morality, trust and loyalty.
The objectives of personnel controls are to:
• clarify expectations by ensuring that employees understand what the
organisation wants
• help to ensure that employees have the capabilities to do the job (i.e.
the necessary experience, intelligence, resources and information)
• enable employees to self-monitor.
Personnel controls require good selection and placement, training, efficient
job design and provision of the necessary resources.
11.4.3 Cultural controls
Cultural controls are built on shared traditions, norms, beliefs, values,
ideologies, attitudes and ways of behaving that are accepted by the group.
The culture of the workplace encourages mutual monitoring and group
pressure on individuals who do not follow group norms. These controls
work best when there are emotional ties within the group.
Organisations have cultures which embody the rules that are acceptable to
them. Some rules are written, others are unwritten. Where cultural norms
are strong, employees feel safe and accepted (as long as they stay within
the norms) which leads to them working well together.
Cultural codes are usually drafted by top management and the legal
department, and are regarded as the fundamental principles of a company.
The codes may be changed due to specific incidents within the company or
industry, legal changes, leadership changes or business strategy changes.
Codes of conduct may – or may not – help to control employee behaviour.
Leadership from the top is important (i.e. top management should be seen
to take the organisation’s codes of conduct seriously).
AC3193 Accounting theory
114
Activity 11.12
Do an internet search for codes of conduct. Some are drawn up by professional bodies,
for example The Nursing and Midwifery Council, others are drawn up by companies, for
example Coca Cola, and some for not-for-profit organisations, for example Action Aid.
If you were working for one of these organisations, would you find the code helpful?
What other parties would be likely to read the cultural code of an organisation?
Make notes of your ideas and discuss these with other students on the VLE.
11.4.4 Encouraging effective cultural and personnel controls
Group-based rewards
These aim to motivate cooperative and effective working of the group
towards organisational goals. The rewards may be profit-sharing for all
employees or group rewards.
Open book management
This idea involves making much more financial and other information
available to employees so that they can see the effects of their actions on
the company’s performance. Employees must be trained to understand the
information and how they can contribute to the company’s performance
and earn group rewards.
A culture change may be needed from the top-down approach, which
exists in many organisations, in order to encourage employees’ ideas and
enable their ideas to be implemented.
Intra-organisational transfers of employees or employee
rotation
This activity encourages employees to work in different parts of the
organisation. It can help to develop a wider understanding of the
interconnectedness of the different activities in an organisation. It can also
deter collusion in fraud by stopping employees becoming too familiar with
a department’s activities, colleagues and processes. Care must be taken to
make this a positive experience for employees who are transferred.
A policy on whistle-blowing is required to ensure that employees
who experience or observe wrong practices (e.g. fraud, bullying of
subordinates) are able to speak out, knowing that they will be protected
and that action will be taken (see also Chapter 19.)
Physical and social arrangements
Office layouts that encourage collaborative working can be positive. Social
arrangements should be agreed in discussions between employees and
management (e.g. dress code and institutional habits).
Tone at the top
Leaders need to be role models.
11.4.5 Summary
Cultural codes are general, relating to all employees or a group of
employees. Personnel controls build on the culture of the organisation and
encourage personal responsibility. Action controls focus on particular ways
to do specific tasks or roles.
Chapter 11: Introduction to control systems – personnel controls, cultural controls, action controls and results controls
115
11.4.6 Proactive and reactive controls
Many measures are proactive to prevent problems from occurring (e.g.
expenditure approvals, computer passwords and dividing up duties).
Other measures are reactive (i.e. measuring the activities as they happen
and intervening to correct actions if necessary). The purpose is to guard
against people in the organisation either from doing something they
should not do or not doing something that they should do.
Activity 11.13
Give an example of how your school, college or university uses both proactive and
reactive controls.
11.5 Results controls
The issues below relate to Merchant and Van der Stede (2017) Chapter 3
which you can read either before, or in conjunction with these notes and
activities. The concept of results controls is that employees should feel
that they are in business for themselves, and that their actions will lead
to better or worse implications for themselves. For this to work effectively
for the organisation, goal congruence is needed so that the actions which
benefit the employee also benefit the organisation, and employees are
enabled to see the consequences of their activity. Employees are therefore
empowered and motivated to use their judgement to develop the best way
of achieving the required outcomes.
Results controls are mostly used for controlling the behaviour of
professionals and managers, that is ‘Someone who is responsible for
achieving a result rather than performing a task’ (Hammer, 1996).
Results controls are needed if an organisation is to become decentralised.
11.5.1 Steps
Defining performance dimensions
People work towards the goals and measurements that are set for them,
which means that what is measured tends to get done. If performance
dimensions are not correctly defined, employees will not be working
towards the correct goals (e.g. if a maintenance department were
rewarded based on the number of repair jobs they completed within a
specified time frame, they would give priority to jobs that took the shortest
time to complete and more complicated jobs, which might be critical to
operations in the production area, would be put at the bottom of the list,
even if this disrupted output).
Measuring performance
Many performance measures can be financial (e.g. return on assets). Non-
financial measures such as market share are also common and, as they are
in number form, they are easy to measure. Other non-financial measures
require judgement (e.g. employee traits such as taking the initiative).
These are often recorded on a scale of, for example, one to 10.
In the manufacturing area, measures such as output per hour and amount
of unproductive time may be used.
A situation may arise in which the required financial performance needs
to be translated into operational performance. This is sometimes called a
hinge or linking pin process.
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If more than one results measure is used, the weighting of each should be
made clear to employees so that they are aware of what their priorities
are.
Setting performance targets
Once performance measures are decided, the level of expected
achievement must be agreed between employees and their managers.
Providing rewards
Although rewards are often financial, other rewards that make employees
feel empowered and effective can be equally important (e.g. promotion,
job security or recognition).
The rewards should encourage the greatest motivation, but they must also
be cost effective. For rewards to be effective, they need to be valued by
the individual employee. Some may prefer immediate cash bonuses, while
others may prefer increased pension contributions or more interesting
work.
Activity 11.14
What is involved in the following steps that are used to implement results controls?
• Defining performance dimensions
• Measuring performance
• Setting performance targets
• Providing rewards.
Make notes of your ideas and discuss these with other students on the VLE.
11.6 Conditions needed to implement effective results
controls
11.6.1 Knowledge of desired results
It is not always easy to determine performance targets for each role within
an organisation in such a way that profitability (or effectiveness in a not-
for-profit organisation) is always improved. It is also important to give the
right weightings to each activity. Using the wrong measures or weighting
can lead to employees performing the wrong actions.
11.6.2 Ability to influence desired results (controllability)
Employees must be able to affect the results that are measured by their
own actions. If employees have little ability to control their activity, then it
may not be possible to use results controls.
11.6.3 Ability to measure controllable results effectively
The purpose of results controls is to motivate employees to perform the
appropriate activities. Results measures should be precise, objective,
timely, understandable and cost-effective. If it is very difficult to measure
the results efficiently, then results control may not be the correct method
to adopt.
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117
Activity 11.15
Why is each of the following important?
• Knowledge of desired results
• Ability to influence desired results (controllability)
• Ability to measure controllable results effectively.
Make notes of your ideas and discuss these with other students on the VLE.
11.7 Reminder of learning outcomes
Having completed this chapter, and the Essential reading and activities,
you should be able to:
• explain why an understanding of management control is important for
managers in all areas of an organisation
• describe the management process in terms of objective setting,
strategy formulation and management control
• discuss some causes of management control problems
• explain the terms: action controls, personnel controls and cultural
controls
• identify, for each of these types of control, ways in which it can be
implemented, the most appropriate conditions for its use and the
problems that should be considered
• explain results controls and describe the steps required to implement
them
• identify the conditions needed to implement effective results controls
and discuss why they are important.
11.8 Case studies
1. Read the case study ‘Leo’s Four-Plex Theater’ at the end of Merchant
and Van der Stede (2017) Chapter 1, pp.22–23, then answer the
following questions:
• What does the theatre’s control system lack?
• What control improvements would you suggest?
2. Read the case study ‘EyeOn Pharmaceuticals’ at the end of Merchant
and Van der Stede (2017) Chapter 3, pp. 114–19, then answer the
following questions:
• How would you categorise the control strategy used in the
research and development area?
• Evaluate the control strategy. What, if anything, should EyeOn
managers do differently?
• How can the productivity of research and development be
measured?
11.9 Test your knowledge and understanding
1. Describe action controls, personnel controls and cultural controls.
Explain why, with so many other controls available, results controls are
also used.
Notes
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Chapter 12: Control system tightness and control system costs
119
Chapter 12: Control system tightness and
control system costs
12.1 Introduction
In Chapter 11, we identified different methods of controlling and
encouraging good work performance. In this chapter, which draws on
Chapters 4 and 5 of Merchant and Van der Stede (2017), we will look in
detail at how controls can be designed to encourage the most efficient
and effective working environment. We then turn to consider the costs
of designing, implementing and sustaining a control system. The costs
involved are both direct costs as well as the costs that result from poor
design, which can lead to time being wasted by following the wrong goals
and manipulating the situation so as to appear to be following the right
goals.
We finish the chapter by considering the issues that arise where companies
have divisions in different countries or environments and therefore
cannot necessarily adopt the same systems across the whole organisation.
The knock-on effect will be that there will be more expense involved in
designing appropriate systems, but in the long run it is likely to be more
cost-effective to do this than to have an inefficient operation.
12.1.1 Aims of the chapter
This chapter aims to:
• outline the issues involved in creating a well-designed management
control system
• give a summary of the direct and indirect costs of operating the
system.
12.1.2 Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• explain the issues to be considered in implementing tight results
controls
• explain the issues to be considered in implementing tight action
controls
• explain the issues to be considered in implementing tight personnel
and cultural controls
• identify, in general terms, the direct costs of management control
systems
• describe behavioural displacement related to results, action and
personnel and cultural controls
• describe gamesmanship, creation of slack resources, data manipulation
and operating delays
• explain the negative attitudes that may arise through poor design of
controls
• identify the types of situation where adaptation of control systems may
arise.
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12.1.3 Essential reading
Merchant, K.A. and W.A. Van der Stede Management control systems:
Performance measurement, evaluation and incentives. (Harlow: Pearson,
2017) 4th edition [ISBN 9781292110554] Chapters 4 and 5.
12.1.4 Further reading
Hofstede, G. Culture’s consequences: international differences in work-
related values. (Beverley Hills, CA: SAGE Publications, 2001) [ISBN
9780803913066].
Ma, J. ‘Dear investors: letter from Jack Ma as Alibaba prepares roadshow’,
Financial Times [London, UK] 5 September 2014. Available online at www.
ft.com/content/54a53a50-353d-11e4-aa47-00144feabdc0
Petruno, T. ‘Sunrise scam throws light on incentive pay programmes’, Los
Angeles Times [Los Angeles, CA] 15 January 1996. Available online at
http://articles.latimes.com/1996-01-15/business/fi-24821_1_incentive-
pay-plans
The Economist ‘Tesco’s accounting problems not so funny’, The Economist
[London, UK] 27 September 2014. Available online at www.economist.
com/business/2014/09/27/not-so-funny
12.1.5 References cited
Hofstede, G. Culture’s consequences. (Beverley Hills, CA: Sage Publications,
2001) Second edition [ISBN 9780803973244].
‘Dear investors: Letter from Jack Ma as Alibaba prepares roadshow’, Financial
Times, 5 September 2014.
12.2 Control system tightness
The issues below relate to Merchant and Van der Stede (2017) Chapter 4
which you can read either before, after or in conjunction with these notes
and activities.
An important decision in all areas of organisational control is ‘how tight
should controls be?’. This is related to the definition of the action to
be controlled, the ability to measure it accurately and the rewards or
penalties of meeting – or not meeting – the target.
All controls must be specific, and the desired results must be
communicated and accepted by those being controlled. Where the
controls can be used exclusively in a particular performance area, the
controls should be complete (i.e. they should cover all areas of expected
performance).
12.2.1 Issues to be considered in the design of good results
controls
Congruence
In order to be effective, results controls must be goal congruent (i.e.
they should guide the manager to make decisions that are in line with
the organisation’s objectives). This requires that the objectives are well
understood.
Activity 12.1
Give two examples of ambivalent objectives, either from your own experience or from
Merchant and Van der Stede (2017).
https://www.ft.com/content/54a53a50-353d-11e4-aa47-00144feabdc0
https://www.ft.com/content/54a53a50-353d-11e4-aa47-00144feabdc0
http://articles.latimes.com/1996-01-15/business/fi-24821_1_incentive-pay-plans
http://articles.latimes.com/1996-01-15/business/fi-24821_1_incentive-pay-plans
http://www.economist.com/business/2014/09/27/not-so-funny
http://www.economist.com/business/2014/09/27/not-so-funny
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Specificity
Managers must know specifically what their targets are. These are
often financial, which is realistic when actions lead to easily measured
outcomes, but is more difficult in some areas of a business and in some
types of industry or organisation.
Activity 12.2
Describe two situations when it is difficult to set easily measurable targets, either from
your own experience or from Merchant and Van der Stede (2017).
Communication and internalisation
Managers must understand what their targets are and have a desire
to meet them. They must understand what they need to do in order to
achieve them.
This can vary due to:
• employees’ qualifications
• the extent to which the managers feel they have control to meet the
measured results
• the manager’s participation in the goal-setting process and the extent
to which they consider the targets achievable.
Completeness
The measures should cover all the areas over which the manager has
control. Areas that are not measured tend to be ignored as energy is put
into those that are measured. The difficulty is that some areas are difficult
to measure.
Activity 12.3
Give two examples of how unmeasured areas may be disregarded by employees, either
from your own experience or from Merchant and Van der Stede (2017).
Performance measurement
Measures need to be precise, objective, timely and understandable.
Incentives
Results controls are most effective if there are consequences from meeting
or not meeting targets that have been set.
The expected actions and the rewards must be linked. Two types of link
can be used. A direct link translates performance into specific additional
rewards. Usually achievement is highly rewarded and failure receives little,
if any benefit. A definite link means that no excuses will be considered
and failure leads to high penalties.
Activity 12.4
Describe two examples of penalties resulting from missing targets. Use the internet to
research some recent examples.
Tight controls and too tight controls
Some very routine activities can be measured closely using modern
technology (e.g. devices scanning employees’ actions).
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Care must be taken to ensure that these actions are considered reasonable
by those being measured. Communication and discussion between
management and employees is vital. This will ensure that management
can find out whether a measure is acceptable and that employees can
understand the purpose of the control. Employees might be able to suggest
better approaches since they are doing the day-to-day work.
Activity 12.5
Describe an example of this sort of monitoring. You can follow this up by looking
at the discussion about this subject on the ACAS website: www.acas.org.uk/index.
aspx?articleid=5721
12.2.2 Issues to be considered when designing tight action
controls
The aim here is to ensure that employees whose work is controlled by
action controls are doing things correctly and do not have opportunities to
make mistakes or commit fraud.
Behavioural constraints
This involves physical and administrative ways to encourage correct
behaviour, such as:
• physical – locks, passwords, restricted access to information
(dependent on job responsibility)
• administrative – restricting decision-making authority and ensuring
that higher level employees do not become indispensable
• separating duties – ensuring that no one person can complete a
transaction.
Employees may override internal controls or collude to hide mistakes or
perpetrate fraud.
Pre-action reviews
These involve checking before a new activity is implemented or changes
are to be made to improve current working. Reviews should be frequent
and should investigate the situation in detail. They should be performed
by diligent, knowledgeable reviewers. They are mostly used where a
significant investment is proposed, particularly when it is irreversible and
thus affects the fortunes of the organisation (e.g. business plans, projects
requiring capital investment).
These reviews may also be used to keep down day-to-day spending
and may include tactics like using black-and-white photocopies and
double-sided printing only to ensure that, before a division commissions
management consultants, they have checked that the expertise does not
exist in-house.
Activity 12.6
Do an internet search on how companies keep their costs down. You will find some
interesting examples.
Action accountability
This creates specific rules or ways of working which become the measure
for appraisal, reward or punishment. Unacceptable behaviour must also
http://www.acas.org.uk/index.aspx?articleid=5721
http://www.acas.org.uk/index.aspx?articleid=5721
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be defined. It can be effective if the policies and guidance are understood
and accepted. These can be improved by the participation of employees in
setting the rules and by communication and training.
These measures work well where the required actions are routine and well
defined, and where adhering to them is important, for example:
• for safety in hospitals, care homes or nuclear power facilities
• for the prevention of fraud in, for example, banks.
Tight control measures are not suitable for the parts of a job that require
skills, judgement, discretion or creativity. In these areas, appropriate action
cannot be closely defined. Tight controls may limit employees’ judgement
and creativity, delay decisions, erode morale and frustrate highly skilled
employees.
Action tracking
If rules are to be enforced, actions must be tracked. This is becoming
easier with modern technology. It is essential, since it is important that
employees know that they will be caught if they do not follow the rules.
Action reinforcement
Rewards and punishments for not keeping to the rules must be known
and enforced. There must be sufficient expert knowledge to observe and
expose the ways in which employees do – or may be able to – bypass the
controls. This is particularly true in companies where systems are largely
performed using IT, where sufficient controls may not be incorporated
because the IT expertise in the organisation is not sufficient.
Where tight controls have been implemented, care must be taken to
ensure that they are not eroded when activities are reorganised. During
the reorganisation, some procedures that are in place as checks and
balances may not be understood and may be considered as non-value
adding or inefficient.
12.2.3 Issues to be considered in the design of tight personnel and
cultural controls
Personnel and cultural controls focus on developing good work
performance that results from employees being motivated and
experiencing self-satisfaction from performing well. This is reinforced by
a positive corporate culture that encourages people to feel part of a team
and to not want to let the team down. Loyalty is also encouraged.
The controls are intended to encourage and improve the employees’ work
ethic and team norms (e.g. at interview stage enabling candidates to
observe the work ethic and commitment of other workers). There should
be group incentive plans, which require regular training with rewards for
attendance. There should also be training in ethics.
Activity 12.7
Using information from the section ‘Tight personnel/cultural controls’ in Merchant and
Van der Stede (2017), make notes on how Kellogg and Dell have implemented improved
understanding of the company’s ethics.
Discuss your thoughts with other students on the VLE.
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12.3 Control system costs
12.3.1 Introduction
The aim of implementing management control systems (MCS) is to
create a higher probability that employees will pursue the organisation’s
objectives. Although there is a benefit to the organisation, the design,
implementation and monitoring of MCS nevertheless costs money.
The easiest costs to identify are direct costs, but there may also be indirect
costs caused by poor control design or using the wrong type of control.
These costs may be difficult to identify and quantify.
Direct costs
Direct costs are all the costs that are incurred in designing and
implementing MCS. These can include procedures manuals and staff
training as well as the work that goes into such activities, such as time
spent on monitoring staff, planning and budgeting, and pre-action
reviews. Organisations also need to factor in the payment of bonuses and
maintenance of internal audit staff.
Organisations should attempt to determine how much of the work
identified above is routine checking and how much is undertaken to
enable strategic goals to be realised. This helps to indicate whether it
is possible to reduce costs without harming the implementation of the
strategy.
It is important that the activities of internal checking and internal audit
are transparent, both inside the company and externally, as great harm
can be done to a company’s reputation if it becomes apparent that robust
financial controls are not in place.
(Note that the topic of internal auditing is not covered on this course.
AC3093 Auditing and assurance introduces students to this subject.)
Activity 12.8
Read through the case study of PNB Paribas in the section ‘Direct costs’ in Merchant
and Van der Stede (2017) Chapter 5 to understand the importance of monitoring the
behaviour and decisions of staff.
Indirect costs
Indirect costs are the result of the MCS being ineffective or creating
problems. It is unlikely that there is any organisation that does not have
some activities performed by employees that do not contribute to the well-
being of the company (e.g. gamesmanship, operating delays or negative
attitudes).
12.3.2 Behavioural displacement
This occurs when the design of the MCS produces and encourages
behaviour that is inconsistent with an organisation’s objectives.
Behavioural displacement and results controls
These outcomes are what takes place when the results measure is
incongruent with the true objectives of a company. When the measure is
too broad to focus on important activities or if there are too many ways in
which the measures can be met or the organisation has focused only on an
easily quantifiable measure, then it is likely that this will occur. In these
situations, employees will find ways to meet the targets with the least
effort on their part, possibly resulting in poor overall performance.
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Activity 12.9
Now take a look at the five bullet points in the section ‘Indirect costs: Behavioral
displacement and results controls’ (p.187) in Merchant and Van der Stede (2017) Chapter
5. Choose two of these examples and make notes on how better controls could be
implemented. (These will be formally covered in later chapters, but for now put yourself
in the employee’s position and think about what would encourage you to focus more on
effective work rather than just meeting targets.)
Discuss your notes with other students on the VLE.
It is often difficult to find measures that capture the activities of a
role sufficiently to encourage behaviour that is focused on strategic
performance. ‘There are very few jobs, even presumably simple jobs, where
what is counted is all that counts – in other words, results controls are
almost invariably incomplete’ (Merchant and Van der Stede (2017) p.175).
Behavioural displacement and action controls
The problem of means-ends inversion occurs where employees focus
on the actions they have the authority to perform rather than on what
they are meant to accomplish (e.g. managers are given a top limit on the
amount they can spend on capital expenditure so invest in several small
projects, even though each of the projects is suboptimal).
Action controls may be incongruent, and because employees need to stay
within the rules, they become ineffective. An example of this can be found
in the case of a computer customer advice centre where advisers were
required to spend no longer than 13 minutes on each call. No commission
was paid on longer calls. Staff found ways to cut calls off, but customer
service ratings dropped below the industry average, with the result that
the company’s reputation was damaged.
Some action controls can be so rigid that they do not give employees
the opportunity to try out better ways of performing a task. This
level of control may be good in stable environments with centralised
knowledge, but can stifle change and innovation in competitive, fast-
changing situations. However, detailed rules do have an important role in
circumstances where health and safety are paramount.
Behavioural displacement and personnel/cultural controls
This displacement usually arises when the wrong type of employee is
recruited, the training is poor or the cultural controls are implemented in
the wrong setting.
Activity 12.10
Read the case study of Levi Strauss in the section ‘Behavioural displacement and
personnel/cultural controls’ in Merchant and Van der Stede (2017) Chapter 5. Make
notes of the steps you would have taken to deal with the problem of workers injuring
themselves in the course of trying to meet piecework goals.
Discuss your notes with other students on the VLE.
12.3.3 Gamesmanship
Gamesmanship occurs when actions are taken by employees to improve
their performance indicators without producing an improved performance.
Below are two examples.
Creation of slack resources
This is a well-known device which enables managers who are appraised
on performance to negotiate lower targets or more resources than they
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may need to perform their task. This often occurs when managers risk loss
of bonuses, pay rises or promotion if targets are missed. Slack can lead
to wasted resources and obscures underlying performance. However, a
certain amount of slack can relieve a manager’s stress, provide a cushion
against unforeseen change and enable innovation to be implemented. This
is discussed in more detail in Chapter 19 of this subject guide.
It is only possible to eliminate slack in highly stable conditions with
predictable outcomes so forecasts can be set from the top down and there
is no information asymmetry.
Data manipulation
This can be seen in two ways:
1. Falsification: this involves reporting data that has been changed.
2. Data management: this is action that is taken to make performance
look better without there being any real economic advantage to the
organisation. It can involve moving activity to a different time period
(e.g. ‘saving sales’ for the next budget period if the target for bonuses
in the current period has already been met or making results look
worse in a poor period so that the next period will look better by
comparison).
Data management can be implemented by using accounting actions and
operating actions.
Accounting action can mean changing accounting methods that
the organisation uses (e.g. depreciation rates or methods of revenue
recognition).
Operating actions can include deferring expenditure (e.g. on
maintenance) or trying to accelerate sales (e.g. by recognising as sales
goods that are in the hands of distributors but have not actually been sold
and so could be returned to the company by the distributors).
Activity 12.11
Read the section ‘Data manipulation’ in Merchant and Van der Stede (2017) Chapter
5, and then read The Economist article ‘Tesco’s accounting problems. Not so funny’ (27
September 2014) at www.economist.com/business/2014/09/27/not-so-funny
Use it to explain Tesco’s sales activity, as a result of which the auditor PwC considered
issuing a warning that there was a ‘risk of manipulation’.
Alternatively, do an internet search to find a similar issue with another company (e.g.
McDonald’s).
These actions, which report improved accounting income, can have
serious effects on the business in the future. Examples of this include:
aggressive sales tactics can harm customer satisfaction; saving sales
can lead to increased overtime payments in the next period to meet the
additional sales demand; or employee productivity may be reduced due to
underspending on maintenance.
Manipulating data by affecting the accuracy of the company’s information
system can lead to management relying on erroneous data when making
decisions and forecasts.
http://www.economist.com/business/2014/09/27/not-so-funny
Chapter 12: Control system tightness and control system costs
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Activity 12.12
Read the section ‘Data manipulation’ in Merchant and Van der Stede (2017) Chapter 5,
and then look at the Los Angeles Times article ‘Sunrise scam throws light on incentive
pay programmes (15 January 1996) at http://articles.latimes.com/1996-01-15/business/
fi-24821_1_incentive-pay-plans
Then explain why Sunrise Medical’s bonus plan led to outright fraud.
12.3.4 Other costs of action controls
Operating delays
Controls such as unreasonable limits on access to certain areas (e.g.
stockrooms) or passwords needed to access information that needs to be
reviewed regularly can be very time consuming. This may be minimised by
introducing up-to-date electronic methods (e.g. retina recognition).
Major delays can be caused by requiring multiple layers of approval for
action from different levels of the hierarchy. This not only potentially
means that actions are delayed, which could result in lost sales or
production output, but can be demoralising for employees who know their
area of expertise and can see opportunities being missed due to lack of
authorisation. This can also lead to managers and employees going ahead
with actions or spending money first and getting authorisation afterwards
(act first and apologise later).
12.3.5 Negative attitudes
Feeling disempowered and/or ignoring controls can not only lead to
wrong decisions being made but can affect an employee’s whole attitude
to the controls in place. This might lead them to ignore other constraints
on their behaviour. Alternatively, they may experience tension, frustration
and conflict leading to absenteeism, lack of effort and higher staff
turnover. Pressure to hold onto one’s job due to economic pressures and
the need for job security can encourage unethical conduct.
Negative attitudes produced by results controls
Employees may have negative reactions to the controls because the targets
that are set are too difficult, not meaningful or they are not able to control
them. If the targets are too difficult, employees feel too pressured, and if
this involves a number of people, this could lead to industrial action.
Inequitable rewards and most forms of punishment can cause negativity.
Even the target setting process may not be welcomed, particularly if it is
poorly implemented. Participation in the process can help to create an
acceptable system.
While weaker employees may be negative because the system may uncover
their inadequacies, stronger employees may be negative about flaws in
the system. This could lead to some of the harmful behaviours we have
already discussed.
Negative attitudes produced by action controls
If action controls appear to set in motion micro-management of employees’
activities, they may be resented by responsible employees who consider
that they are being ‘checked up on’. There may also be cultural and
location issues which call for different action controls in different
situations or countries. This is something that multinationals need to
consider when imposing a system in different environments.
http://articles.latimes.com/1996-01-15/business/fi-24821_1_incentive-pay-plans
http://articles.latimes.com/1996-01-15/business/fi-24821_1_incentive-pay-plans
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Activity 12.13
Read the examples in the section ‘National culture’ in Merchant and Van der Stede (2017)
Chapter 5. This describes the merger between the Bank of America and Merrill Lynch, and
the different attitudes to action controls in 7-Eleven Japan when it expanded to America.
Make notes as you do this reading, and discuss your thoughts with other students on the
VLE.
12.4 Adaptation of control systems
Management control systems which are working in a particular situation
may need to be adapted when they are implemented in different scenarios
(e.g. as mentioned above, in different countries or cultures). This also
applies to businesses that have different parts undertaking different
operations (e.g. services or products) or where some divisions are
expected to pursue different strategies from others.
Multinational companies usually have significant decentralisation and
may have divisions operating in different industries and in different parts
of the world. They will be using financial results controls to monitor
performance. These organisations may experience information asymmetry
with divisions that will know their own business well. This makes it harder
to determine which controls are effective.
12.4.1 National culture
National culture has been defined as ‘the collective programming of the
mind that distinguishes the members of one group or society from another’
(Hofstede, 2001).
Thus employees from different cultures must perceive controls as
culturally appropriate (i.e. they must fit with the shared values of the
society from which the employees come). The characteristics of a national
cultural and the political and economic environment are likely to affect
a company’s corporate goals. American companies are most likely to put
shareholders first, whereas in China there is a culture of putting ‘customers
first, employees second and shareholders third’, according to Jack Ma of
the Alibaba Group, a multinational technology conglomerate (Financial
Times, 2014).
This, in turn, affects the MCS that will be suitable to be adapted in a
different country or society.
12.4.2 Local institutions
Countries will differ with regard to:
• regulations on corporate governance and governance interventions
• company law, contract law and employment law
• the existence and strength of trade unions
• the effectiveness and efficiency of financial markets in raising capital
and the rules on disclosure
• the strength of regulations, auditing and enforcement.
All these will be important in setting, especially, results controls.
12.4.3 Difference in local business situations
Business environments can differ significantly across countries as well as
within different countries. This will affect an organisation’s ability to use
the same MCS in different places.
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Regional uncertainty can be seen in:
• military conflicts, kidnapping, terrorism and extortion threats
• corporate espionage and theft of company secrets by competitors
• developing countries where there may be limited access to capital,
weak accounting regulations and poor enforcement of contract
violations.
All of these issues will affect whether a company should set up in another
country. If it does make the decision to go ahead, it will need to decide
on ways of protecting a division and setting performance targets that will
need to be unique to that circumstance.
Governments in different regions take different attitudes to business
intervention. There may be limits on businesses being able to set up due
to government-granted business permits. Price controls and restrictions
on the flow of currencies may be in place. Governments may act to
give preference to local businesses rather than foreign companies. The
countries’ tax laws and employment laws must also be considered.
Inflation may differ from country to country and will often affect
currency rates between countries. High inflation can have an effect on
asset values and erode the value of employees’ earnings. Monitoring
financial performance in this situation may require the implementation of
inflation accounting to mitigate the effect of inflation on asset values and
performance. Alternatively, there may be a flexible budgeting process that
will protect managers from the risk of inflation. The company could also
put greater emphasis on non-financial indicators.
Employees in some developing countries may be less educated or skilled.
This may lead to a preference for more centralised decision structures and
more emphasis on action controls than results controls. Small divisions
may make the separation of duties for internal control difficult.
A national corporate culture that assumes lifetime employment will
require different approaches to long-term incentive plans and may affect
recruitment as the available talent pool will be a smaller.
Activity 12.14
Explain the problems with foreign currency translation and identify four suggested ways
of dealing with the problem. (If you need help with answering this question, refer to
Merchant and Van der Stede (2017) p.186.)
12.5 Summary
As we have seen, creating an effective MCS is complex and every area
must be reviewed regularly by managers to enable the system to be
effective for every employee. It needs to be tight enough and specific
enough to encourage the meeting of strategic goals, but at the same time,
it must be seen as fair and appropriate by the employees and managers
who are required to operate the system.
12.6 Reminder of learning outcomes
Having completed this chapter, and the Essential reading and activities,
you should be able to:
• explain the issues to be considered in implementing tight results
controls
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• explain the issues to be considered in implementing tight action
controls
• explain the issues to be considered in implementing tight personnel
and cultural controls
• identify, in general terms, the direct costs of management control
systems
• describe behavioural displacement related to results, action and
personnel and cultural controls
• describe gamesmanship, creation of slack resources, data manipulation
and operating delays
• explain the negative attitudes that may arise through poor design of
controls
• identify the types of situation where adaptation of control systems may
arise.
12.7 Case study
1. Read the case study ‘PCL: A breakdown in the enforcement of
management control’ at the end of Merchant and Van der Stede (2017)
Chapter 4, pp.168–72, then answer the following questions:
• Analyse the challenges faced by PCL in reducing returned sets and
no fault found (NFF) returns.
• Apart from the recommendations already put forward by PCL,
what other actions might improve the return rate of TV sets?
• What lessons can PCL draw from its exercise in controlling the
high rate of returns of TV sets to inform its execution of internal
control mechanisms in the future?
12.8 Test your knowledge and understanding
1. Explain the term ‘behavioural displacement’ and give examples of how
this can arise in relation to:
• results controls
• action controls
• personnel/cultural controls.
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Chapter 13: Designing and evaluating
management control systems.
Identifying financial responsibility
centres
13.1 Introduction
This chapter focuses on the design and evaluation of the various controls
discussed in previous chapters and how they should be used. It looks at
what activities and behaviour are desirable and what is likely to happen.
The difference between the two indicates where controls should be
introduced or changed.
The chapter continues by considering the types of responsibility centres
that are created to enable the use of results controls and the methods of
transfer pricing which are used when different responsibility centres trade
with each other.
13.1.1 Aims of the chapter:
This chapter aims to:
• draw together the issues already covered in Chapters 11 and 12 of
the subject guide relating to the design and use of different types of
control
• focus on results controls and how they are used in different
responsibility centres
• explore in detail the purpose of transfer prices and the different types
of transfer price which companies may use.
13.1.2 Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• discuss the different situations in which different types of control are
most effective
• describe different types of responsibility centres and give examples of
each type
• describe different methods of setting transfer prices
• explain the situations in which each method is likely to be used and
the limitations of each method.
13.1.3 Essential reading
Merchant, K.A. and W.A. Van der Stede Management control systems:
Performance measurement, evaluation and incentives. (Harlow: Pearson,
2017) 4th edition [ISBN 9781292110554] Chapters 6 and 7.
13.1.4 Further reading
Horngren, C.T., S.M. Datar and M.V. Rajan Cost accounting: A managerial
emphasis. (Harlow: Pearson Education, 2015) 15th edition [ISBN
9780134475585] Chapter 22.
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13.2 Designing and evaluating management control
systems (MCS)
The issues in this section relate to Merchant and Van der Stede (2017)
Chapter 6 which you can read either before, after or in conjunction with
these notes and activities.
Designers of MCS need to have some knowledge of a company’s objectives
and strategies. This enables work descriptions, targets and rewards to be
developed. To make these work effectively, MCS design must be tested to
see if control problems – such as lack of direction, motivational problems
or personal limitations – will mean that key actions will not be performed
and key results will not be achieved. If there is evidence of this, then
the controls must be adjusted to make them effective: ‘The discrepancy
between what is desired and what is likely will determine the
choice and the tightness of the management control systems’ (Merchant
and Van der Stede (2017) p.221).
13.2.1 Personnel/cultural controls as an initial consideration
These controls have few harmful side effects and are cheap to implement.
In some small organisations where a team spirit and good day-to-day
communications are possible, these may be the main control systems.
Activity 13.1
Read the examples of good and bad corporate culture in the section ‘Personnel/cultural
controls as an initial consideration’ in Merchant and Van der Stede (2017) Chapter 6.
Make notes on how a good culture can be maintained as a company grows.
13.2.2 Action and results controls
Advantages of action controls
• Action controls are the most direct form of control. It is easy for
employees to identify what should be done and the emphasis is on
performing actions correctly the first time.
• Creating documentation of the required actions accumulates
knowledge of what works best. The policies and procedures developed
are an organisational memory which enables the transfer of knowledge
to new employees.
• Action controls aid organisational control.
Disadvantages of action controls
• Action controls can only be used for highly routine tasks.
• If not properly designed, the controls may be used on the part of a task
which is easily measurable but of lesser importance (e.g. encouraging
fast throughput of products which leads to poor workmanship and
rejected units). This in turn leads to behavioural displacement.
• Action controls discourage adaptation and innovation. Employees
assume they are not required to be creative and become passive and
resistant to change.
• Employees may become sloppy or cut corners.
• Action controls may cause negative attitudes from creative employees
who want to use their judgement and initiative. This may motivate
them to leave the organisation, leading to high staff turnover and
higher training costs.
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• Action controls which require preaction reviews by superiors can be
expensive. This is because reviewers will be more highly qualified, so
their time is more expensive. Also, delays may occur because they are
busy with their own responsibilities. However, these reviews must be
carried out properly if they are considered necessary.
Activity 13.2
Read the examples of good and bad experiences of action controls in the section
‘Advantages and disadvantages of action controls’ in Merchant and Van der Stede (2017)
Chapter 6. Make notes of the different types of action controls that are described and
discuss these with other students on the VLE.
Advantages of results controls
• Results controls are feasible when the desired results of the action
can be set, but the way in which the results will be achieved is not
known. Employees are expected to use their skills and judgement to
assess the possibilities and implement those that will work best in the
circumstances.
• They encourage creativity and new and innovative ways of thinking.
• Results controls allow employees to be autonomous.
• Organisations can provide on-the-job training as employees learn by
doing and making mistakes.
• Results controls are relatively inexpensive to monitor as they do not
require a high level of supervision.
Disadvantages of results controls
• There is the possibility of congruence or alignment problems due to
imperfect knowledge of the desired results.
• Good measures should be precise, objective, timely and
understandable. Results controls do not fit these requirements and so
it is difficult to tell whether good actions have been taken.
• Often results are affected by factors other than the employees’ skills.
• Targets set are often required to meet multiple, important, but
competing, control functions (e.g. budgets for motivation should be
challenging, for planning they should be realistic and for coordination
they should be conservative to ensure that resources are not wasted).
• Measures may be too many and conflicting.
Activity 13.3
Read the examples of factors that affect results, important but conflicting control
functions and conflicting measures in the section ‘Advantages and disadvantages of
results controls’ in Merchant and Van der Stede (2017) Chapter 6.
Then think of and describe a situation where you have been given responsibility to do
something but without enough information to be sure you have done the right thing.
13.2.3 Control system tightness and adaption to change
Tight systems are most important in the areas that are most critical for
the company’s success. The level of tightness must be assessed for each
situation and may change over time.
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Activity 13.4
Read the section ‘Simultaneous tight-loose controls’ in Merchant and Van der Stede
(2017) Chapter 6. It describes how a strong culture can enable tight-loose controls to be
implemented. Then makes notes on what you have read.
As organisations grow or respond to their changing environment, the
controls that are in place will adapt. Feedback on the effectiveness of
each control may lead to different types of control being considered.
(See Chapter 12 of the subject guide, where there is a list of many of the
situations where change may be needed.)
The appropriateness of any control is measured by the behavioural
response from those performing the activity that is being measured.
Therefore management need to be sensitive not only to whether the
expected results are being achieved, but also to whether employees
continue to feel that they are relevant and acceptable.
13.3 Identifying financial responsibility centres and
transfer pricing methods
The issues in Sections 13.2 and 13.3 relate to Merchant and Van der Stede
(2017) Chapter 7 which you can read either before, after or in conjunction
with these notes and activities.
Financial results control systems
All types of controls have been reviewed in terms of their features,
appropriateness and limitations. In the following sections of this chapter
we will focus on results controls, in particular financial results controls.
We will consider the operations and limitations which arise in specific
situations. These issues can be measured using financial targets; they
require employees to use their initiative and judgement in order to meet
the requirements of their responsibilities.
It should be remembered that results controls only measure certain aspects
of a job and an employee who is being assessed will also follow action and
personnel/cultural controls as part of their job. For example, a salesman
may have a sales target to meet (results control) which requires that they
show initiative in finding customers and negotiating deals. The salesman
will be required to deal with customers within the organisation’s ethical
guidelines (personnel/cultural control) and complete the relevant forms to
activate the production and dispatch of the goods that have been ordered
(action controls).
Advantages of financial results controls
• Financial controls are a necessary and important part of the success
of for-profit organisations (and are needed for the effective use of
resources by not-for-profit organisations).
• They allow managers to maximise the monetary effect of operating
initiatives which must be either income generating or money saving.
• They enable top management to assign targets to different
responsibility centres and measure the results without having to micro-
manage the actions that lead to the results. Top management will only
get involved where results indicate that there are problems (although
this can lead to employees manipulating results, as discussed earlier).
• Financial measures are relatively precise, compared to softer measures.
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• The costs of operating and supervising the controls are small, relative
to other controls.
Disadvantages of financial results controls
• Financial results controls are very specific and usually relate to a
particular time period (often a year). This can encourage managers to
focus on improving the yearly results by making decisions that may
not be goal congruent for the whole organisation.
• They may discourage investment in activities which are needed for the
future profitability of the responsibility centre.
These are very important issues and we will look at them in depth in
Chapter 15 of this subject guide.
13.3.1. Financial responsibility centres
The most important aspect of a responsibility centre is that its purposes
must be well defined and the resources available and authorisations made
clear. It is within this framework that a manager has responsibility and
within which they must achieve their financial targets.
The financial targets may be very general (e.g. a target return) or they
may be more specific (e.g. the preparation and agreement of a budget to
meet the financial target). As with all controls, there should be defined
consequences of meeting or not meeting the target.
Responsibility centres usually fall into one of four categories: revenue,
expense, profit or investment centres, as detailed below:
Revenue centres
Here managers are held accountable for generating revenues, for example:
• sales departments in commercial organisations
• fundraising managers in not-for-profit organisations.
These centres are not profit centres. Revenue targets are set and the costs
of running the centre are monitored separately. For example, in a sales
department the expenses will include the sales manager’s salary, salespeople’s
salaries as well as commissions and the costs of running the department.
In a fundraising department, these expenses will include managers’ and
administrators’ salaries, departmental running costs and, possibly, fundraising
costs, depending on where the responsibility for these lies
Expense (cost) centres
Here managers are held accountable for the expenses or costs of running
the responsibility centre.
These centres are usually categorised as ‘standard’ or ‘engineered’
cost or expense centres, where both the input (e.g. materials, labour,
etc.) and the output (i.e. products and services) can be easily measured. A
production department or a dental practice are examples of these types of
centres. The inputs and outputs can be measured in monetary terms and
there is a causal relationship between inputs and outputs. This enables the
costs to be estimated in relationship to the output (e.g. standard costs can
be flexed to represent actual output).
Or they can be categorised as ‘discretionary’ or ‘managed’ cost
or expense centres. These types of centres provide services to other
centres, and it is often difficult to measure output in monetary terms.
Examples of these include administration, personnel, accounting and
finance, research and development and maintenance departments. The
financial results controls are usually based on an agreed budget which
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may be set incrementally depending on previous experience or may use
some sort of zero based budgeting.
Some organisations convert these centres into profit or break-even centres
by requiring them to charge the departments who use their services. This
is sometimes done by charging market rates and allowing departments
to use external suppliers, thus creating a market. This runs the risk of the
internal department sitting by idly while the user departments are paying
external providers. It also requires a transfer pricing decision to be made.
Profit centres
A profit centre is a part of the business where managers are held
accountable for generating profits (i.e. the manager has significant
influence over both revenues and costs). It is distinguished from an
investment centre in that there is no discrete investment over which the
manager has decision-making control.
The advantage of a profit centre is that it enables the manager to run the
centre as a business. They can make trade-offs between revenues and
costs, and the measures they are likely to take are comprehensive because
the centre can incorporate all the financial aspects of performance.
The advantage of being able to make trade-offs encourages some
organisations to turn sales revenue centres into profit centres by charging
the standard cost of the products to the centre. This requires them to be
answerable for gross profit not sales. Cost centres can be converted into
profit centres as discussed above.
Activity 13.5
Read the section ‘Profit centres’ in Merchant and Van der Stede (2017) Chapter 7,
where you will find examples of cost centres being changed into profit centres by being
empowered to charge revenues. Make notes of the behavioural issues and problems with
price setting which can arise, and discuss these with other students on the VLE.
Investment centres
These are units where revenues, costs and the investment required
to generate returns are identified and where the manager has some
decision-making control or responsibility for the use of all three. There
may be some discretion over which level of profits and which assets the
investment centre manager has responsibility for – for example, should a
proportion of head office costs be charged to the centre?
The financial measures may involve a ratio of net income earned to capital
employed. In some organisations this is regarded as the target when
setting a comprehensive budget which will take into account the strategic
role of the division and any plans to change the assets during the year.
Monitoring throughout the year is then performed relative to the budget.
In other organisations, where investment units largely perform the same
function in different locations, a ‘beyond budgeting’ approach may be used
which measures each unit against the other units using key performance
indicators as well as net income or return on investment.
The different centres described above are convenient labels. In practice,
any variation or hybrid which works for a particular company will be
adopted.
When creating appropriate centres, it is important to follow the lines of
responsibility of each centre and include the items which the manager
should pay attention to.
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13.4 Transfer pricing
13.4.1 Definition
The transfer price is the artificial price that is set by a company which
has products or services that are transferred between profit centres,
investment centres or break-even centres within the same organisation.
The transfer price affects the revenues of both the supplying profit centre
and the costs of the buying profit centre. Hence, the profits of both entities
will be affected in an equal and opposite fashion. The effect on the pre-tax
net income of the company as a whole will usually be unaffected by the
level of the transfer price.
13.4.2 Purposes
The purpose of transfer pricing is to:
• Provide information to motivate centre managers to make economic
decisions in the best interests of both the centre and the group. The
pricing should appropriately influence the decision on how much
to transfer internally. This can be affected by constrained or spare
capacity in the supplying centre. If one centre is at capacity and cannot
supply the product, the buying centre may need to check whether
another centre can meet the demand before they buy in from external
sources. This situation may be helped by reducing the transfer price
when there is spare capacity.
• Make available information that is useful for evaluating the economic
and managerial performance of the division. This is important for
motivation and performance appraisal, and also helps with the
allocation of resources within the company.
• Maintain each manager’s autonomy in running their centre. The
transfer price method should enable the manager to make good
economic decisions. Therefore, once a method is adopted, interference
from top management can lead to poor decision-making and delays.
13.4.3 Top management intervention to maximise group
performance
In order to maximise the net income of the group, top management may
intervene to move profits between company centres or locations.
This may be used:
• for tax purposes where a company is operating in different tax
jurisdictions so that more profit is declared in the area where taxes are
lower
• where a centre is in a joint venture with another company, profits may
need to be moved from that centre to another centre within the group
– it is usual for the transfer prices to be set in the contract with the
joint venture to avoid possible expropriation
• if a company is trading in countries which restrict the repatriation of
profits (possibly because of balance of payments problems or scarcity
of foreign exchange funds), transfer prices can be used to transfer
funds to the home country.
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Activity 13.6
Imagine that you work for a company that has centres that trade in both high tax areas
and a low tax areas. Assume that your company has a centre trading in a country which
restricts repatriation of funds, and that it has a trading centre and a head office in a
country where there are no restrictions.
Explain how the transfer price would be set to reduce taxes and/or enable repatriation of
funds, if the centres are selling different products to each other.
13.5 Methods of setting transfer prices
13.5.1 Introduction
It is important to recognise that some transfer prices can only be used
in certain circumstances, so the ‘best’ price will be the most appropriate
one for the particular situation. Often the method for implementing the
transfer price will be set by top management, but this may not mean that
this will be only method that is used throughout the organisation.
Choosing the appropriate transfer price is most important when a significant
proportion of the centre’s trade is made by divisional transfer and is thus
represented by the transfer price. If trade between two divisions is, say, 2%
of the total sales value or purchase value, even an inappropriate method
will hardly affect the centre’s decision-making or results.
The descriptions and explanations below refer to situations where the
centres trade within one jurisdiction.
13.5.2 Market-based pricing
Market based with perfect competition
This is defined as the existence of a ‘perfectly’ competitive external market
(i.e. no individual buyer or seller can affect the price).
The transfer price is based on the actual price that is charged to
customers. If there is no market price for the particular product required
by the buying division, the price of a similar product can be used,
adjusted for differences between the transferred product and the product
sold to customers. The differences may be the result of packaging costs,
difference in quality or other specific features. If neither of these are
available, the price that a competitor would charge can be used.
Because the market price will be used for trading with an external buyer
or seller, in many cases this method helps both the selling and buying
managers to make an optimal decision from a corporate viewpoint.
If a seller cannot earn a profit from trading at market price, it is
economically unsound for the buying division to pay more to prop up
the division. This would also lower the buying centre’s profits. Therefore
the buying centre will buy from outside suppliers. Similarly, if the buying
division cannot make profits by buying at market price, it should close
down that part of the business.
Market-based price with imperfect competition
Most businesses operate in imperfect markets. However, if they are selling
the same or similar products or services to other centres as they are selling
to external customers, the same price can be used since this represents
the opportunity forgone from not selling externally. The situation may
be different, though, if the loss of sales to other centres would create
spare capacity. This is discussed below. If a supplying centre can supply a
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product that is currently being bought by the buying division externally,
the transfer price is the external price currently being paid. But if the
buying division is happy with the current supplier, it may be necessary
for a lower price to be offered if the buying division wishes to obtain the
work.
Distress market prices
This occurs when a selling centre has already bought a commodity and
the price has gone down significantly but temporarily. Normally the seller
could decide to wait until the market readjusts, but if another centre wants
the commodity it will buy it externally for the distress price, which is not
good for goal congruence since the buying centre already holds inventory.
Top management may intervene and suggest an average price between
the distress price and the normal price. This intervention would need to
be taken into account when appraising divisional performance of both
divisions.
13.5.3 Cost-based methods
Full cost plus
This method calculates both variable and fixed costs for a product or
service and a profit percentage is added. Where a market price is not
available, and both centres are profit or investment centres appraised
on net income, this method is an approximation of market price. It is
considered fair because it allows the selling centre to earn a profit on
internally transferred products or services. The prices are not quite as
responsive to market conditions as the market price but they provide a
measure of long-run viability which is important for both the buying and
the selling centre.
The method is relatively easy to implement because companies have cost
systems in place to calculate the full cost of production.
One of the disadvantages of this is that the seller knows that the actual
cost will form the price and so does not need to be careful to control costs.
This can be mitigated by basing price on standard cost.
Another is that the full cost calculated may not represent the current cost
of production. In many cases historical cost depreciation is included and
the allocation of overhead costs may not have been done using a detailed
approach such as activity-based costing.
It may also be difficult to determine the percentage of profit which should
be added.
Full cost based
This method only uses the variable and fixed costs. It therefore does not
provide a profit for the selling division and gives a reduced price to the
buyer in comparison to it being bought from an outside supplier.
The difficulty with this method is that there is no incentive for the
selling centre to do internal transfers since there is no profit margin and
the selling centre’s profit is understated due to there being no profit
element. The buying division obtains the goods at a price that is lower
than if an outside supplier were commissioned.
Therefore, this method is not suitable where the selling division is a profit
centre. However, it may be used by management for charging a service
department’s costs to user departments to help make decisions about
whether to use the service departments. This cost calculation could use an
ABC analysis.
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Decision-making anomalies have been observed when full cost plus (or
market price) are used in situations where the selling centre has spare
capacity and the buying centre could sell more of the final product if the
product price were reduced. In order to make that decision, the buying
centre needs to know the total variable costs incurred by both centres to
decide by how much the price can be reduced. Even knowing this is not
sufficient to motivate the manager to expand, as the reduced price may
cut the total net profit of the centre, even though it would increase total
corporate profits. The selling centre would see increased profits as a result
of selling more at the same margin as before. To resolve this issue, some
organisations use marginal cost for the transfer price.
Marginal cost based
This price excludes upstream fixed costs and profits. Therefore, the
marginal costs remain visible for the centre that finally sells to outside
customers. However, it provides poor information for evaluation purpose
as the selling centre cannot even cover fixed costs so it incurs a loss and
the profits of the buying centre are overstated.
It is therefore rarely used in practice without some adjustment,
which is discussed below.
Marginal cost plus a lump-sum fee
In this case the marginal cost of each unit is paid and a lump sum for the
use of capacity is agreed and paid regularly to the selling centre from the
buying centre.
The marginal cost of the transfer remains visible and the selling centre
can recover its fixed cost and a profit margin through the lump-sum fee.
However, the fee has to be based on the predetermined amount of use
made by the buying centre of the selling centre’s capacity. Therefore it is a
problem to estimate how much capacity should be ‘reserved’ for internal
sales.
Marginal cost plus proration of contribution
In this case, the monthly payment made by the buying division to the
selling division is based on the total contribution made by the finished
product. This is divided between the two divisions on some reasonable
(agreed) basis.
13.5.4 Dual rate
This method is rarely used, but it is another way to meet the issues
described above. It involves charging and crediting different prices to
the centres. The selling centre receives the market sales price and the
amount charged to the buying centre is the marginal cost of production.
This creates a difference that may be taken into an account and used to
reconcile the differences when consolidating the financial statements.
There would also need to be an adjustment when appraising the results of
the buying division whose net income will be overstated.
Advantages
Dual rate provides the proper economic signals to the centres for decision-
making and correct information for the evaluation of the seller centre.
It ensures that internal transactions will take place, whereas the other
methods may be considered too complicated by the selling centre.
Disadvantages
In terms of decision-making, dual rate destroys incentives for the buying
centre to negotiate favourable outside prices from suppliers (as the buying
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centre now only pays the marginal cost). It destroys incentives for the
selling centre to improve productivity because it finds ‘easy’ sales inside
the organisation. Dual rate also distorts the buying division’s profits
for evaluation purposes. This would also need to be adjusted for when
appraising the results of the buying division whose net income will be
overstated.
13.5.5 Negotiated price
Transfer prices are negotiated between the selling and buying centre
managers themselves. This method ensures the autonomy of the divisional
managers when compared to methods imposed by head office. It also
allows for flexibility in uncertain conditions.
For this method to work effectively, both centre managers should have
the option to use alternative suppliers or buyers as this will increase
their bargaining power. If the transaction is a small part of one centre’s
operations but a large part of another centre’s operations, then there will
be a power imbalance.
The price may not be economically optimal, but may rather depend on the
negotiating skills of the managers involved.
It is may be costly in terms of management time and this may accentuate
conflicts between centre managers. This method may also require
corporate management intervention.
13.5.6 Simultaneous use of multiple transfer price methods
Even though the methods used may not be perfectly suited to both
decision-making and performance evaluation, it is rare to use more than
one system for the same transactions. The simultaneous use of the multiple
transfer price method is mainly used to meet the needs mentioned above
of moving profits between jurisdictions. Here international (OECD) rules
restrict how the transfer price can be calculated and different countries
may also have rules governing this area.
13.6 Reminder of learning outcomes
Having completed this chapter, and the Essential reading and activities,
you should be able to:
• discuss the different situations in which different types of control are
most effective
• describe different types of responsibility centres and give examples of
each type
• describe different methods of setting transfer prices
• explain the situations in which each method is likely to be used and
the limitations of each method.
13.7 Case study
1. Read the case study ‘Diagnostic products corp (DPC)’ at the end of
Merchant and Van der Stede (2017) Chapter 6, pp.233–41, then
answer the following questions:
• Evaluate the design of the performance bonus system at DPC for
US-based field service engineers (FSEs) as it currently exists and
the way that the programme is being implemented. What changes
would you suggest, if any?
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• Instead of using results controls like the performance bonus
programme, could DPC control its US-based FSEs using only action
and personnel/cultural controls?
13.8 Test your knowledge and understanding
1. With regard to discretionary expense centres, explain how targets are
determined and appraisal is conducted.
Incorporate in your answer examples of these centres, including
some that have fairly easily identifiable outputs and some that have
difficulty in identifying outcomes. Explain how selling their services to
other departments might be useful and what problems might arise.
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143
Chapter 14: A detailed look at planning
and budgeting
14.1 Introduction
As already discussed in previous chapters, setting targets, measuring
results and rewarding performance are vital aspects of management as
they give focus to employees’ activities.
This chapter looks at the role of budgeting in contributing to the
performance of these tasks and the behavioural advantages and
problems which arise as a result. In profit-seeking organisations, it is
essential to ensure that the planned activities contribute to the expected
financial results. The activities should also meet the strategic aims of the
organisation. This involves all managers being committed to meeting their
revenue and cost targets in order to achieve these goals. However, setting
these financial targets will involve the participation of top managers and
the functional managers involved, so that they all understand the issues
that each party is likely to face and the financial targets they are prepared
to agree to.
14.1.1 Aim of the chapter
This chapter aims to:
• outline the purposes, processes and pitfalls of planning and budgeting.
4.1.2 Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• explain the main purposes of budgeting
• identify the three budgetary planning cycles and explain why each one
is necessary
• describe different ways of setting targets
• discuss the reasons for setting highly achievable targets and the
situations in which this may not be suitable
• describe ‘beyond budgeting’ and explain why it has been advocated.
14.1.3 Essential reading
Merchant, K.A. and W.A. Van der Stede Management control systems:
Performance measurement, evaluation and incentives. (Harlow: Pearson,
2017) 4th edition [ISBN 9781292110554] Chapter 8.
14.2 Budget purposes
14.2.1 Planning
Successful organisations plan their strategy several years in advance so
that they can be proactive, rather than reactive, in their environment.
They need to identify the strengths and weaknesses, opportunities and
threats, and determine how these might affect different aspects of their
organisation. These plans require both external information as well as the
views and expertise of the managers who will be required to implement
the plans within the organisation. This ‘thinking ahead’ process should
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involve all relevant personnel in considering the practical actions that need
to be taken to meet the organisation’s strategic aims. Financial impacts
must be attached to these actions to ensure that the financial targets will
be met.
This is known as feed-forward control, that is comparing predictions of
expected outcomes with desired outcomes and taking corrective actions to
minimise any differences.
The budgeting process involves drawing up a detailed financial plan that
focuses on the next period (usually a year) and represents the practical
activities that are needed to work towards the strategic goals. It should
include every aspect of the business and ensure that all managers are
committed to the outcomes they have agreed to.
Activity 14.1
Read the examples in the section ‘Purposes of planning and budgeting’ in Merchant
and Van der Stede (2017) Chapter 8 of companies who are successful because of
their commitment to comprehensive budgets and are thus prepared to meet future
opportunities.
Make notes about how, if you were a production manager, you would prepare to meet
changing sales targets and discuss these with other students on the VLE.
14.2.2 Coordination
No plan can work without coordination and if this is not properly planned,
this is an area where it would be easy for one part of the organisation
to assign blame to another. The coordination between upper and lower
management, and horizontally across departments, to ensure that
everyone is involved and informed, is vital to the smooth and efficient
running of the operation throughout the year.
Top management oversight
Before they are adopted, plans and budgets must be examined, discussed
and approved at successively higher levels of management to ensure
that they are feasible. The aim is to provide a challenging but realistic
plan, one that incorporates performance targets that can be monitored
using management by exception. Positive or negative variances give top
management early warning of unforeseen opportunities or potential
problems. These can lead to the organisational strategy being reconsidered
or to the activities of subordinate managers being redirected to rectify the
situation.
14.2.3. Motivation
The agreed budgetary target and the actions it represents gives managers
a goal to work towards. Clear, simple and challenging – yet attainable –
goals encourage good performance.
14.3 Planning cycles
14.3.1 Strategic planning
As mentioned above, the strategic plan decides the direction for several
years (three to five, but even up to 10, depending on the type of
business). This provides the strategies for different entities and identifies
the resources that will be needed. This plan informs the annual budget
and it is put together with information from the top management team,
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including representation from the research and development, marketing
and production divisions. It may include the development of new products
and new regions. The plan will also include a review of the existing
products and regions to determine any appropriate action that is necessary
to make them more viable or to discontinue them. There will be a review
of the possibilities of moving into completely new commercial fields.
14.3.2 Capital budgeting
This involves more than just evaluating expenditure on non-current assets.
It includes identifying steps to implement the agreed specific expansion
and replacement programmes for the next few years. The strategy to
implement the required internal activities will be incorporated.
Each part of the company will identify their needs by reviewing their
existing activities and how they need to be adapted. This may include,
for example, finding a new sales outlet, developing employee skills or
employing personnel with different expertise as well as possibly acquiring
new equipment. This is not necessarily a mechanical process as resources
may be limited and managers with good bargaining skills may affect the
direction of the strategy.
A group of corporate managers will be actively involved in the process.
They might review large programmes and help to communicate corporate
priorities, to avoid issues arising due to a lack of direction. They will
also perform preaction reviews to define how any new investment will
be implemented. This is a form of action control that helps functional
managers to understand where their activities fit into the organisation’s
portfolio of activities. Functional managers therefore have a focus and
an opportunity to represent their issues and problems, which gives
the process a bottoms-up aspect. The final aim is to ensure that the
programmes adopted are in each case aligned with corporate objectives
and strategies.
14.3.3. Operational budgeting
This budget operationalises the work done in strategic and capital
budgeting to create revenue targets and to make provision for sufficient
expenses to meet the organisation’s goals. Budgets are usually set for
12 months, coinciding with the financial statements, and identify the
activities expected of each responsibility centre.
14.4. Target setting
The budgets, once agreed, become targets that the managers will have to
meet. Ensuring that the budget is met will be a part of their evaluation and
may also be linked to incentives. Performance review, including variances
from the budget, is an opportunity to evaluate effectiveness and efficiency,
and inform organisational learning by, for example, finding savings or,
where variances are favourable, building on the actions that led to the
favourable outcomes. These reviews can therefore lead to continuous
improvement.
14.4.1 Setting financial targets
Targets can be set by:
• A quantitative model (engineered targets): examples of this
include time and motion studies that identify the time and resources
needed to produce output and which attach current costs to these
resources (a good example is standard cost). These costs will be flexed
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by output each period. These models are usually monitored with tight
controls because the link between effort and results is clear.
• Incremental budgeting: this is based on historical performance
and is adjusted to include expected changes from the previous year.
They may be agreed after negotiations, as department managers may
know more about expected changes than higher management. Once
these budgets are agreed, the appropriate level of control must be
set. It may be possible to use tight controls, but this also encourages
managers to exaggerate potential cost increases in order to build in
slack, so looser controls may be more suitable.
• Zero-based budgeting: this requires managers to start from zero
and justify every expense. It is the preferred method when a company
is taken over and efficiencies through cost cutting are expected.
• Negotiation: this is a process of negotiation between lower and
higher level managers. They will attempt to bridge the asymmetric
gap between higher management who know more about overall
organisational incentives and resource constraints, and lower level
managers who are more aware of the business opportunities and
constraints at the operational level. Fairly loose controls may be more
suitable at this level as there may be great uncertainty about the
period ahead.
• Setting targets using relative (internal) performance:
companies with highly controlled operations that are similar in all
their branches (e.g. fast food outlets) may use relative performance as
part of the targets that a manager is expected to achieve.
• Using external benchmarks to set targets: as part of their
strategy, companies will consider where they stand in their industry.
From there, it is a logical step to set targets that are measured against
their competitors, both in terms of setting operating margins but also
in more detailed areas such as product quality, customer service, etc.
Activity 14.2
Read the examples of industry benchmarking in the section ‘Internal versus external
targets’ in Merchant and Van der Stede (2017) Chapter 8. Then do an internet search to
find further examples of benchmarking.
14.5 Recasting the budget
Many companies find that because the budgeting process needs to start
well before the financial year commences, by the time the budget is
operational or within a few months of the beginning of the year, the
budget needs recasting. This means that the original budgetary targets
remain the same but many of the cost and revenue budgets must be
realistically revised, otherwise the variances will be meaningless. Since,
at the profit centre level, the performance targets remain the same,
responsible managers must use their commercial skills to adjust their
activities to the new environment.
14.6 Common financial performance target issues
14.6.1 How challenging should financial performance targets be?
Motivational theory suggests that people make most effort when the
targets they have been set are difficult but possible to achieve (see
Figure 8.1 in Merchant and Van der Stede (2017) Chapter 8). However,
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if the targets look too difficult and employees feel as if they are likely to
fail to meet them, they will stop trying. This attitude is also affected by
personality and the degree of uncertainty of the task.
In practice, studies have shown that, at the profit centre level, targets are
set at a highly achievable levels (e.g. they will be achieved 80 to 90% of
the time). This is not easy as it requires a consistently high level of effort.
Setting highly achievable targets works because this:
• Increases managerial commitment: managers feel that, despite
having a difficult job they can achieve the targets and so they will
make the effort to do so. Managerial commitment is vital because
the measurement covers a long budget period. If a manager is
unmotivated from the start and fears that targets are unachievable,
this will be compounded by uncertainty in the environment in which
the centre is operating. In turn, decreased motivation may result
in poor decision-making. This problem of a long budget period can
be helped by setting targets to be achieved within shorter intervals.
However, this is expensive as more detailed budgets will need to be
prepared, which requires more time for the reviewing process.
• Protects against optimistic projections: if sales targets are
expected to be set at highly achievable levels, it means that resources
will be planned to help meet these expectations. More resources will
be acquired if sales are expected to be higher, but if too high a sales
forecast is used, resources may be acquired that cannot easily be
divested.
• High managerial achievement: since managers feel they can
achieve the targets that have been set, they are motivated to do so
and their self-esteem will be high, which will be reflected in their
performance. This can be reinforced by bonus packages for higher
achievement.
• Reduces cost of interventions: because the targets are highly
achievable, intervention by higher management can focus on managers
who are not meeting their targets (see Figure 8.2 in Merchant and Van
der Stede (2017) Chapter 8).
• Reduces game playing: meeting the set targets is very important
to profit centre managers because of the risk of losing bonuses,
promotion and reputation. If it looks as though their targets will not be
met, they will engage in manipulative actions in order to do so. Highly
achievable targets reduce the risk of this happening.
14.6.2 When is it necessary to set challenging profit targets?
If the company is in extreme financial difficulty, setting challenging targets
may signal to managers that short-term profits are a priority over growth.
14.6.3 How much involvement should subordinates have over
setting their targets?
High involvement
• This enhances managerial commitment as the managers understand
better why the targets are set as they are.
• Information-sharing managers are closest to local information, while
corporate managers can share corporate priorities and constraints.
• The process helps cognition – managers have a better understanding of
how to achieve their goals.
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• Managers’ motivation is increased because they have been recognised
as having relevant knowledge and expertise.
Low involvement
• Corporate management has sufficient, or better, information than
subordinate managers.
• Corporate management can evaluate performance on a relative basis
due to running homogenous units (e.g. food outlets).
• This is preferable when lower level managers are not good at
budgeting (e.g. in some small firms).
• Corporate managers have better knowledge than lower level managers
because of high-level decisions that change the way a unit operates.
• Corporate managers may be aware of biases in the management team,
which means that targets should be adjusted (e.g. managers who set
lower targets to make their jobs easier). Optimistic managers may set
targets that are unrealistically high.
14.6 Criticisms of budgeting and consideration of
beyond budgeting
In large, complex organisations it is impossible to get every aspect of
budgetary control completely right. Even if this were possible, it would
be a very time-consuming activity and could cause conflict, feelings of
unfairness and manipulation.
Activity 14.3
Read the section ‘Planning and budgeting practices and criticisms’ in Merchant and Van
der Stede (2017) Chapter 8 to find out how long companies take to prepare budgets and
how many staff are included in this process.
The ‘beyond budgeting’ movement proposes that budgets should not
be produced. Targets and performance indicators should be based on
comparing different business units to each other and against competitors’
performance, using key performance dimensions.
This has worked well, particularly in terms of performance appraisal for
some companies where the business units are fairly homogenous and
so can be compared easily. It is possible, however, that such companies
may still use budgets for planning, coordination and facilitating top
management oversight.
The beyond budgeting movement has criticised budgets as:
• being rife with game playing
• producing only incremental thinking and minor modifications to the
plans of previous periods
• locking the organisation into a fixed, inflexible plan, leaving it unable
to respond to changes
• centralising power and stifling initiative
• separating thinkers (planners) from doers
• causing too many costs for too few benefits.
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14.7 Reminder of learning outcomes
Having completed this chapter, and the Essential reading and activities,
you should be able to:
• explain the main purposes of budgeting
• identify the three budgetary planning cycles and explain why each one
is necessary
• describe different ways of setting targets
• discuss the reasons for setting highly achievable targets and the
situations in which this may not be suitable
• describe ‘beyond budgeting’ and explain why it has been advocated.
14.8 Case study
1. Read the case study ‘Kranworth Chair Corporation (KCC)’ at the end
of Merchant and Van der Stede (2017) Chapter 7, pp. 274–82, then
answer the following questions:
• Identify the key recurring decisions that must be made effectively for
KCC to succeed. In KCC’s functional organisation, who had authority to
make these decisions? Who has the authority to make these decisions
in KCC’s new divisional organisation?
• Did KCC’s management go too far in decentralising the corporation?
Or did they not go far enough? Or did they get it just right? What are
the reasons for your choice?
• Evaluate KCC’s new performance management and incentive scheme.
If KCC retains its new structure, what changes would you recommend?
• Assuming that the R&D is decentralised to the divisions, would this
necessitate making changes to KCC’s performance measurement
incentive scheme? If so, why and how?
14.9 Test your knowledge and understanding
1. Explain the findings of motivational theory relating to target setting,
and indicate ways in which, at the profit centre level, many companies
interpret these ideas on target setting.
Notes
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Chapter 15: Incentive systems
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Chapter 15: Incentive systems
15.1 Introduction
In this chapter, we will look at appropriate ways in which companies can
reward (or punish) employees’ work. We will also examine the types and
purpose of incentives, how to design a system and how the system can be
evaluated. Different incentives are relevant to different situations and also
to the personal circumstances of individual employees.
15.1.1 Aims of the chapter
This chapter aims to:
• identify different types of incentives
• outline the issues involved in determining appropriate and effective
incentive schemes.
15.1.2 Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• describe the types of incentive that can be used
• explain the purposes of using incentives
• identify the different types of short- and long-term incentives, and
explain the different purposes that are served by using these
• explain why subjective rewards may be used and discuss the
advantages and problems that arise from their use
• discuss the ways in which group rewards are useful and what their
limitations are.
15.1.3 Essential reading
Merchant, K.A. and W.A. Van der Stede Management control systems:
Performance measurement, evaluation and incentives. (Harlow: Pearson,
2017) 4th edition [ISBN 9781292110554] Chapter 9.
15.2 Purposes and types of incentives
15.2.1 Purposes
Well-designed incentives create goal congruence that link an employee’s
self-interest to the company’s goals. The purpose of incentives are:
Informational (effort-directing)
Each incentive informs the employee about the relative importance of the
competing results areas. This may mean that several different measures
are weighted in the overall bonus plan.
Where incentives are focused on the wrong outcomes, these can be
changed in order to direct employees’ efforts to the appropriate area.
Motivational (effort-inducing)
Rewards should encourage the desired behaviours from employees so
extra reward is given if they exert extra effort.
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Attract and retaining personnel
Some companies offer a relatively low basic salary, but have generous
incentive schemes that are paid regularly.
Creating variable costs
Incentive schemes that are performance-dependent have the effect of
making salaries partially variable with company performance.
Activity 15.1
Read the section ‘Purposes of incentives’ in Merchant and Van der Stede (2017) Chapter
9. Then make notes on the Barclays Bank and BP examples, where incentives were given
despite the wrong outcomes. Discuss your notes with other students on the VLE.
15.2.2. Types of incentives
Non-financial
Many incentives are non-financial. Some arise from personnel/cultural
controls (e.g. praise and recognition). Others may result from good
performance (e.g. better job or office assignments, being given more
responsibility or status, or being rewarded with titles, job security, greater
autonomy, power, promotion or opportunities to participate in important
decision-making processes or in executive development programmes).
Some non-financial incentives are ‘perks’ and include things like a reserved
parking place, country club membership, first class travel, merchandise,
prizes and time off, for example.
Financial
Financial incentives include bonuses, salary increases and stock options
(see 15.3 below).
Negative incentives
If an employee’s work is poor, it may be signalled by no bonus being paid,
no salary increase or another kind of penalty. But if this is the case, it may
also be an indication that certain employees need more supervision by
managers, or that the employee should be assigned to less important work.
This could be a demotion or even result in job loss.
15.3 Monetary incentives
Monetary incentives are increases in pay in response to performance.
Different organisations will set up their processes in different ways.
15.3.1 Salary increases
Salary increases are a permanent and continuing change to an employee’s
income. Salary increases that are the result of cost of living increases,
collective bargaining or seniority payments are not specific incentives.
The incentives are awarded on merit, for performance above the norm
with the expectation that this will continue.
15.3.2 Short-term incentives (STI)
Bonuses, commission or piece-work payments encourage employees to
work above minimum expectations. These can be paid annually or more
frequently, depending on the performance being recognised. For example,
piece-work payments and commissions can be paid weekly or monthly.
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Bonuses for achieving or even exceeding financial targets may be paid
yearly. Bonuses can also be paid for non-financial performance areas (e.g.
customer satisfaction or quality management). In some cases, even if poor
financial results have been reported, managers are still been paid bonuses
for meeting other targets that have been set. If this is not acceptable, the
organisation can introduce a modifier; this means that if basic financial
targets are not met, other bonuses will not be paid either.
Surveys suggest that eligibility for bonuses and their size increase as
employees move up the organisation.
Short-term incentive schemes are designed to encourage good operational
decisions in order to maximise performance over a month or year,
depending on the frequency of appraisal. For example, a salesman’s
commissions may be paid monthly, whereas bonuses for departmental
financial performance are likely to be paid yearly.
15.3.3 Long-term incentives (LTIs)
Long-term incentives should motivate employees to achieve long-term
growth and increase the value of the business. LTIs tend to be aimed at
higher levels of management who are in a position to make decisions
that have long-term impact. They encourage senior managers to make
decisions which, even though they may have a poor impact on the current
year’s results, will have a significant effect in subsequent years. LTIs are an
attempt to cope with the problem of short-termism in decision-making and
enable senior managers to share in long-term successes.
Typically an LTI will cover performance achieved over three to four years.
The performance targets to be achieved can be cumulative over the years
or by the end of the period set. The latter can be either consecutive (the
next plan starts at the end of the previous one) or overlapping (a new plan
begins each year). Overlapping LTIs make it easier to enrol newly eligible
executives. The use of overlapping cycles is most common.
Activity 15.2
Create a numerical example of nine years of a division’s net income, with a benchmark
target that must be reached over three years, before an LTI is payable and a percentage
reward given for exceeding that target. Explain how the LTI would be paid on a
continuous three-year basis and an overlapping basis.
Stock option plans
Stock options give managers the right (option) to buy a specific number
of shares in the company at a set price during a particular time period
(usually the price set is the share price on the day the right is offered,
which is known as ‘at the money’). The option can be exercised (vested)
over a number of years (e.g.one-fifth per year for five years) and will
expire at some point (e.g. in 10 years). Managers may be required to give
up their unvested options if they leave the company.
Advantages for the company
• Stock options provide incentive compensation without outlay by the
company.
• The manager only benefits when the share price goes up. Therefore,
managers benefit when shareholders benefit, developing motivation
to work towards improving the company profits. It ties the manager’s
wealth to the company’s future and encourages them to think like
owners.
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• It helps with retention of talent, particularly if options have not been
vested.
• The options create a positive cash flow for the company when the
managers exercise their options and a possible tax-deductible expense.
Disadvantages for the company
• The issue of shares dilutes the total shareholding and can create
downward pressure on share prices.
• Managers may feel encouraged to make riskier decisions as they are
rewarded by share price gains but are not penalised (at least in the
short term) by share price losses.
• Share prices can be volatile for reasons beyond the manager’s control.
• The attractiveness of stock options varies around the world, but has
always been more prevalent in the USA than elsewhere. Due to the
disadvantages described above, it is now not used so much.
Restricted stock plans
Long-term incentives are often paid with company equity rather than
with cash. Increasing the manager’s ownership share in the company
encourages decision-making which contributes to the company’s long-term
growth. The shares cannot usually be sold for a set period of time after
they have been given and would be forfeited if the manager left before the
end of an agreed period.
They tend to be regarded as a retention tool, rather than as a motivational
one for senior executive talent. If an executive leaves the company, they
typically forfeit unpaid long-term incentives that they otherwise might
have earned.
Performance stock or option plans
The idea behind performance stock or option plans is that the shares do
not vest until a particular performance has been achieved. This may be a
share price, but equally this may be an internal measure of success.
There are many different ways in which the stock options or plans can be
organised, depending on the company’s situation.
Activity 15.3
Search the internet for examples of companies using stock plans as part of their LTIs. You
might look at http://fortune.com/2016/03/11/equity-programs/ or another website. Make
notes on what you discover and discuss these with other students on the VLE.
15.4 Incentive scheme design
Management needs to design incentive schemes carefully, and they should
have a clear understanding of the purpose of each incentive before it is
implemented. Employees need to have a good understanding of why the
scheme has been introduced, how it is going to work and how they can
calculate their entitlement.
15.5 Incentive formulas and subjective rewards
15.5.1 Incentive formulas
Employees whose pay is affected by an incentive plan based on a formula
should receive a contract setting out all the details of their entitlement.
These plans are usually based on the expectation that a certain base level
http://fortune.com/2016/03/11/equity-programs/
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of work (threshold) will be achieved and a bonus will only be paid if this is
exceeded.
15.5.2 Subjective rewards
Managers who are responsible for running departments and motivating
employees may be required to have the ability to distinguish between the
performance of different employees. They may also value the opportunity
to use financial rewards subjectively, which are not part of the formulaic
system, so as to recognise individual good performance. Subjectivity can
be used in the following ways:
• All or part of the bonus will be based on the manager’s subjective
judgement about an employee’s performance.
• The weights on some or all quantitative measures are decided
subjectively.
• Subjectivity is used to decide whether or not to pay the bonus.
Why use subjectivity?
• The rewards may be used to recognise a wide variety of evaluation
criteria; at the beginning of an evaluation period, it may not be clear
which activities are most important to emphasise. Choosing the
wrong bases or weightings could motivate employees in the wrong
direction. If the contract remains flexible, employees will be motivated
to do their best and not give up because the target seems impossible.
Equally, if employees do not know what the target is, they will not stop
making an effort once the target is reached.
• Keeping rewards vague means that employees will not try to
manipulate performance measures.
Although these points are useful for managers, how will they affect the
employees? Subjectivity can reduce the risk of employees not being
rewarded fairly if it enables adjustment for things that are outside the
employees’ control and which reduce their ability to meet targets.
However, subjectivity is likely to increase an employee’s risk, if evaluators
judge them on different criteria from those they were expecting.
Subjective evaluations are likely to have hindsight bias. If employees do
not trust their evaluators to make informed and fair assessments of their
performance, they may become demotivated and frustrated.
Employees may try to influence evaluators to give them a better
evaluation. Therefore the use of subjectivity is most valuable when there
is trust and a good working relationship between the employee and the
evaluator.
15.6 The shape of the incentive function
With formulaic rewards, there is usually a lower cut-off of what employees
have to achieve before a bonus is payable to ensure that mediocre
performance is not rewarded. The level of the lower target will probably
partly depend on the possibility of achieving it.
Equally, there may well be an upper limit as well. This is used because:
• A very high reward may not be deserved because of windfall events.
• Employees may take actions that improve the achievements of the
current period at the expense of a future period.
• The company may wish to avoid the situation of an employee earning
more than their superior in the organisation.
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• It is desirable to keep employee earnings fairly consistent so that they
can sustain their lifestyle.
• A faulty design plan could lead to very high rewards.
Activity 15.4
Read the section ‘Size of incentive pay’ in Merchant and Van der Stede (2017) Chapter
9. Then make notes explaining how an incentive pay package can play a part in selecting
employees for a role and how it can make it difficult for the company to attract talent.
Discuss your notes with other students on the VLE.
15.7 Criteria for evaluating incentive systems
Incentive packages will be tailored to a company’s needs so there can be a
wide variety of these. Generally, the rewards from the scheme should be:
• Valued by the recipient. However, this will vary from employee to
employee. The incentive scheme is only part of what attracts an
employee to a job and its importance will vary due to different factors,
such as stages in their career, different lifestyles and their personal
commitments.
• Large enough to have an impact. Small bonuses can be insulting.
Employees may be contemptuous or angry if their efforts are only
rewarded with this sort of recognition.
• Understandable to the employee. Poorly understood schemes will not
encourage the desired behaviour.
• Bonuses should be timely. They should be awarded soon after they
have been earned. This encourages motivation and, as part of the
performance feedback, can help an employee to learn to be more
effective and earn improved rewards in future.
• Durable (long-lasting). The result of this will be that an employee’s
feelings of motivation and encouragement will last as long as possible.
• Reversible if an evaluator makes mistakes. Promotion to a higher
role is usually difficult to reverse, but bonuses promised for the
performance of specific tasks can be withdrawn if necessary.
• Cost effective. The desired motivation must be generated at the least
cost.
Activity 15.5
Read the section ‘Monetary incentives and the evaluation criteria’ in Merchant and
Van der Stede (2017) Chapter 9. Make notes on two different issues that might make
incentive schemes ineffective. Discuss your notes with other students on the VLE. If
possible, work with students who have made notes on two different issues.
15.8 Group rewards
Group bonuses can be useful for cultural control and are important when
group activity is needed and individual contributions are hard to identify.
Individuals in the group will be motivated to work together and anyone
not pulling their weight will be encouraged to do so by the group.
However, group rewards do not provide a direct incentive for individual
employees, so some may not be contributing to the group’s achievements.
This behaviour is likely to be discouraged by group social pressures, but
this may not work if the employee is not a team player.
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Stock-based schemes, by their nature, are group rewards since improved
company performance benefits everyone. However, there is little direct
link between these rewards and employee behaviour and so low-level
managers may feel unable to make a difference to performance and
become demotivated.
In some companies group rewards are part of the organisational culture.
An example is the John Lewis Partnership where employees are the only
people who share in the profits that the company makes.
15.9 Reminder of learning outcomes
Having completed this chapter, and the Essential reading and activities,
you should be able to:
• describe the types of incentive that can be used
• explain the purposes of using incentives
• identify the different types of short- and long-term incentives, and
explain the different purposes that are served by using these
• explain why subjective rewards may be used and discuss the
advantages and problems that arise from their use
• discuss the ways in which group rewards are useful and what their
limitations are.
15.10 Case study
1. Read the case study ‘Harwood Medical Instruments plc (HMI)’ at the
end of Merchant and Van der Stede (2017) Chapter 9, pp. 374–75,
then answer the following questions:
• What was the purpose of the change?
• Calculate the bonus earned by each manager for each six-month
period under the new plan and compare this with the old plan.
• Evaluate the new plan. Is there evidence that it produced the
desired effects? What, if anything, would you change in the new
plan? Explain what and why.
15.11 Test your knowledge and understanding
1. Describe the different types of short- and long-term incentives and
explain the different purposes that are served by using both of these
kinds of incentives.
Notes
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Chapter 16: Financial performance measures and their effects
159
Chapter 16: Financial performance
measures and their effects
16.1 Introduction
Organisations have many aims and responsibilities. These may include
ensuring that products are safe to use, that employees are fairly treated
and work in a safe environment, and that the company recognises its
responsibilities to the local community and the environmental impact
of their activities. However, as well as meeting these obligations,
organisations are required to cover their costs and, in the case of
companies with independent shareholders, must ensure that they
maximise the value of the company to the shareholders who have invested
their money in it.
Investors value the company as the measurement of the discounted total
future net cash flows that the company is expected to make. The discount
rate is set by the likelihood of the cash flows continuing. In a risky
company the discount rate will be high because investors expect a higher
return as they are taking more risk. This is reflected by the company’s
share price.
The company’s value is therefore improved by either increasing the size of
expected cash flows or by making them less risky and therefore reducing
the discount rate.
There is a difference between economic income (as defined above)
measured by the return to equity shareholders and accounting income
measured by using accounting rules. This has important implications for
management control.
16.1.1 Aims of the chapter
This chapter aims to:
• identify the main measures of financial performance used for higher
managerial performance
• review the behavioural effects of the practice and explore some of the
ways in which detrimental effects can be remedied.
16.1.2 Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• describe the advantages and limitations of using market measures of
performance
• explain why accounting measures are widely used
• discuss the reasons why, if a company wishes to encourage forward-
looking decision-making by its managers, accounting measures have
severe limitations
• provide numerical examples of the way in which return on investment
(ROI) and residual income (RI) are calculated and the motivational
issues that the measures are intended to encourage
• explain the purpose of adopting economic value added (EVATM) as a
performance measure and the disadvantages that might result from
using it.
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16.1.3 Essential reading
Merchant, K.A. and W.A. Van der Stede Management control systems:
Performance measurement, evaluation and incentives. (Harlow: Pearson,
2017) 4th edition [ISBN 9781292110554] Chapter 10.
16.2 Using market measures of performance for
managerial appraisal
Market measures use the value created (i.e. the return to equity
shareholders) calculated as follows: the dividends paid during the
measurement period plus the change in the market value of the stocks/
shares.
16.2.1 Advantages
Market measures are easy to measure, therefore if managers are rewarded
with stocks/shares this tends to be regarded as fair, since they will benefit
in line with shareholders.
The measure is available on a timely basis. It is precise, the values are
objective (i.e. they cannot be influenced by the managers), and it is
understandable and cost effective.
16.2.2 Limitations
Controllability
The measure may be influenced by activities beyond the control of the
managers being assessed. Although top management performance can
affect the measures to some extent, they are not an indicator of the
performance of individual employees lower down in the organisation. This
may lead to them being demotivated by the use of this measure.
There are many activities beyond the company’s control which can affect
the share price. Therefore, the measure can be adjusted to ‘relative
performance evaluation’, which holds managers responsible for the
difference between the company’s performance and the changes in the
overall stock market or the stocks of peer group companies.
Economic profit has not been realised
Market measures are based on expectations of the future, not the realised
performance. Therefore incentives will be based on expectations.
Congruence failure
The company’s plans and prospects are not well known to the market –
partly due to the company’s confidentiality issues – so valuations are not
likely to be accurate.
Manager influence
There may be plans which, if generally known, could harm the company
in the long run, but managers may leak some of the plans to the public in
order to increase the company’s share price.
Anomalies in valuation
These could be due to rumours or lack of information or due to the fact
that the company’s stock is traded infrequently.
Private limited companies
A company not trading on the stock exchange cannot use this approach.
As with all incentive schemes, the effectiveness of these measures must
be assessed for each company. Due to some of the problems with market
Chapter 16: Financial performance measures and their effects
161
measures discussed above, many companies use accounting measures, as
well as (or more often than) market measures.
Activity 16.1
Imagine you are a manager of an investment centre division in a company with 12 such
divisions.
What do you think are the good and bad aspects of being rewarded using a market
measure (which would obviously only be available for the company as a whole, as it
uses the company share price)? Make notes of your ideas and discuss these with other
students on the VLE.
16.3 Using accounting measures of performance for
managerial appraisal
Two types of method are usually used:
1. Residual measures: that is, earnings before interest, tax, depreciation
and amortisation (EBITDA), operating profit net income or residual
income (RI).
2. Ratio measures: that is, return on investment/return on capital
employed (ROI/ROCE), return on equity (ROE), return on net assets
(RONA) or risk-adjusted return on capital (RAROC).
16.3.1 Advantages
Accounting measures:
• Give investment centre managers the ability to make trade-offs: a
manager can improve ROI by making trade-offs between revenues,
costs and investments.
• Provide a common denominator: easy comparisons can be made both
internally with other divisions and externally with other companies
and different types of investment (e.g. interest rates).
• Can be timely and objective: profits can be measured precisely and
objectively almost as soon as the financial period (e.g. a month/year)
has finished and auditors can check the figures.
• Are conceptually congruent with the organisation’s profit maximising
goals: other methods (e.g. cash flows, sales or shipments) do not
adhere to accrual principles, so are more difficult to interpret or
compare.
• May be controlled by the managers whose performance is being
evaluated: therefore reports can be tailored to fit with the authority of
any level of manager.
• Are understandable: since accounting measures are commonplace in
business, managers understand them.
• Are inexpensive: accounting measures have to be prepared anyway for
legal and information purposes.
16.3.2 Main criticisms
Accounting measures fail to reflect economic income well because:
• The system is transaction oriented: actions are not recognised unless
and until a transaction occurs (e.g. accounting rules mean that a
company cannot incorporate the advantage of developing a new drug
until regulatory approval is granted).
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• The profit declared is subject to the choice of measurement method:
the annual depreciation charge for a particular asset depends on
estimates of the asset’s life, its scrap value and the depreciation
method used.
• Accounting measurement rules are conservatively based: they
recognise revenue only when it is contractually agreed, but require
companies to write off intangibles immediately and create provisions
against possible losses.
• Financial accounts ignore economic value changes of intangibles which
accountants cannot measure accurately and objectively: investments
in research in progress, skilled workers, information systems and
customer goodwill are expenses that are incurred in a financial year
and do not appear as valuable assets in the company’s statement of
financial position (unless there is an obvious, specific, identifiable,
sellable asset, e.g. football players).
• Profit recognises the cost of debt but ignores the cost of equity capital:
this means that the profits are overstated and it is not clear how much
profit has been earned above the cost of equity capital. This makes it
difficult to compare the results of companies with different mixes of
debt and equity.
• Accounting profit does not recognise changes in risk: a company’s
future cash flows may have become less risky but this is not shown in
accounting profits.
• Profit figures focus on the past: economic value comes from future
cash flows and past performance is not an indicator of future
performance.
Therefore it is not goal congruent to require managers to make decisions
which improve future performance but then measure their performance
using backward-looking, conservative measures. These measures
encourage short-term decision-making, not long-term value creation.
16.3.3 Specific problems with ROI, ROCE and ROE
These measures, based on accounting principles, discourage new
investment which will, in the initial years, increase the asset base more
than the percentage impact from the investment on the income statement.
This reduces the ROI percentage compared with the previous period.
Accounting rules do not recognise gains until they are realised, but
recognise investments when they are made.
Example 16.1
A company has several divisions. Divisions P and Q are each considering
similar projects with the same cash flows which will start at the beginning
of year 1. The projects both have the following cash flows:
£,000
Investment £1,800
For each of the following 5 years the cash flows will be :
Revenues £900
Cash expenses £300
The budgeted ROI, without the new project for each division at the end of
year 1 is:
Chapter 16: Financial performance measures and their effects
163
Division P Division Q
£000 £000
Net assets at end of year £3,800 £6,000
Net income £604 £1,200
ROI 604/3,800 15.8% 1,200/6,000 20%
Assessing the viability of the projects using discounted cash flow at the
company’s cost of capital of 14%:
Present value of £1 at 14%
Year Discount factor Cash flow Discounted cash flow
£000 £000
0 1 (1,800) (1,800)
1–5 3.433 600 2,060
Net present value 260
The company would be happy if either or both divisions adopted the
project. However, if the managers are awarded bonuses based on their
annual ROI, they will not want their ROI to decrease.
Assuming straight line depreciation, the ROI for each division, with the
new project would be:
Project Division P Division Q
without
project
with project without
project
with project
£000 £000 £000 £000 £000
Net assets: end of year 1,440* £3,800 5,240 £6,000 7,440
Net income 240** £604 844 £1,200 1,440
ROI 16.7% 15.8% 844/5240 16.1% 20% 1440/7440 19.4%
*Net assets (£000) = cost less one year’s depreciation at 20% = 1.800–
360 = 1,440
** Net income (£000) = cash flow – depreciation – 600–360 = 240
Division P would be happy to accept the project as it improves the
division’s ROI, but Division Q might reject the project as ROI is reduced in
the first year.
In subsequent years the ROI of the project will increase due to the
accumulated depreciation which reduces the asset base by £240 (000) per
year but net income remains constant, as follows:
Project Year 1 Year 2 Year 3 Year 4 Year 5
£000 £000 £000 £000 £000
Net assets at end of year 1,440 1,080 720 360 0
Net income 240 240 240 240 240
ROI 16.7 22.2 33.3 66.7 infinite
As well as investing in new projects, managers need to replace existing
assets regularly because of wear and tear. The impact of depreciation
shown above deters managers from replacing assets, so they may continue
to use old assets which have been fully depreciated even though the repair
costs and manufacturing disruption are costly. Replacing assets to improve
efficiency before they are fully depreciated also impacts on the net income
in the year of changing the assets. It may reduce net income due to loss
on the sale of the asset as well as impacting on the asset base in a year in
which the cost savings have not yet been fully realised.
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The above illustration also shows problems that may arise when two
divisions are considering a joint investment, the capital cost of which
will be shared equally. The impact of the investment may improve one
division’s ROI but reduce the other division’s ROI. That division would
probably refuse to take on their share of the project. Thus the opportunity
would be lost – to the detriment of the company as a whole.
Activity 16.2
Using the above example, consider the behavioural impact on the two divisions, if the
company’s cost of capital were 20%. Would the managers’ decisions still be good for the
company? (To help you answer this question, see Merchant and Van der Stede (2017)
Chapter 10, Tables 10.1.and 10.2.).
These measures also:
Can discourage spending on intangible developments
Spending on activities which benefit the future (e.g. research and
development projects, employee training and development, acquiring new
customers, etc.) are all expenses in the period in which they are incurred
but the revenues of cost reductions will be experienced in the future.
Can destroy existing personnel cooperation and lose
customers
Cost cutting to improve short-term profits might mean that employees are
required to work harder or use lower quality materials in the products,
thus making them inferior. In the long run, these actions can lead to staff
turnover, loss of customers and increased product returns and repairs.
Can encourage channel stuffing
Sales are boosted by dropping prices if customers buy in bulk near the end
of the financial period. This recognises more revenue in that period.
Can encourage obtaining operating leases rather than
purchasing assets
Operating leases (as opposed to finance leases) do not have to be
capitalised, so do not increase the company’s asset base. However, they
are usually more expensive in the course of the asset’s life than purchasing
assets would be.
16.3.4 Residual income (RI)
Residual income can be a possible solution to some ROI measurement
problems. It uses the same net income and net asset values as ROI. But
instead of calculating a percentage return, RI reduces the net income by
charging for the use of net assets. It is calculated by using the company’s
weighted average cost of capital multiplied by the value of the net assets.
Example 16.2
(Using the same factors we encountered in Example 16.1)
Division P Division Q
Before After Before After
£000 £000 £000 £000
Net assets at end of year £3,800 5,240 £6,000 7,440
Net income £604 844 £1,200 1,440
Less capital charge 14% on net assets 532 734 840 1,042
Residual income 72 110 360 398
Chapter 16: Financial performance measures and their effects
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The new investment impacts on both divisions’ residual income by the
same amount (i.e. £38,000) so motivates both managers to accept the
proposal. However, in the same way that ROI increases as the assets
depreciate in value, the residual income will also increase over time due to
depreciation without any improvement in net income.
RI is stated as a number, not a percentage, so effectively is only comparing
performance over time within that division. It cannot be realistically
compared with other divisions as larger divisions have larger RI purely
because of scale.
Activity 16.3
Create a numerical example to show that divisions with the same ROI but different scales
(e.g. twice as large) have different residual incomes.
16.3.5. Economic value added (EVA™)
Stern Stewart, a consulting organisation, developed this version of RI in
the 1990s. Their main concern was that some of the financial accounting
rules distorted net income and investment (net assets). They proposed
that the figures should be adjusted for such costs as R&D, advertising,
employee development and goodwill. These costs are normally written
off in the year in which they are incurred, which reduces net income,
but using this approach, costs would be capitalised and written off in the
future periods that benefited from them.
The formula is:
EVA(™) = Conventional divisional net income + accounting adjustments –
cost of capital charge on divisional assets + accounting adjustments.
This method of measuring performance should encourage managers to
invest in forward-looking activities as they know that their net income will
only be reduced by the amount used during the current year and the rest
of the expense will be charged in later periods.
Issues with EVA(™)
Although the measure is referred to as ‘economic’, it does not address all
the differences between accounting income and economic income.
EVA(™) requires judgement to determine which costs to capitalise and over
which years to charge them. This could allow managers to adjust their net
incomes by charging more or less of the intangibles against net income in
order to report more favourable net incomes.
It may be difficult for managers to understand the measure, so they may
not necessarily be encouraged to perform in the desired ways.
Activity 16.4
If you were a member of the top management team considering adopting EVA(™), what
rules or guidelines would you adopt for divisions in order to ensure that intangibles which
are capitalised are later written off in subsequent periods. What problems do you foresee
if guidelines are not provided or monitored? Make notes of your ideas and discuss these
with other students on the VLE.
16.3.6. Comparing divisional performance using current cost
accounting
Difficulties are sometimes encountered when comparing performance
between different divisions if HCA is used. This mostly arises in relation to
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non-current assets because younger divisions will have bought their assets
in more recent years. Due to inflation, particularly of land, the assets are
more expensive than the assets of older divisions. This results in younger
divisions facing higher net assets and higher depreciation than older
divisions, leading to reduced net income and ROI or RI.
Historical cost accounts can be adjusted to current cost accounts using
annual indices to change the asset values. This method also reduces the
net income as enhanced depreciation charges are made to cover the
new value of the assets. This technique is also used in countries with
hyperinflation to create comparability with previous years and identify the
aspects of trading that have been affected by inflation.
16.4 Reminder of learning outcomes
Having completed this chapter, as well as the Essential reading and
activities, you should be able to:
• describe the advantages and limitations of using market measures of
performance
• explain why accounting measures are widely used
• discuss the reasons why, if a company wishes to encourage forward-
looking decision making by its managers, accounting measures have
severe limitations
• provide numerical examples of the way in which return on investment
(ROI) and residual income (RI) are calculated and the motivational
issues that the measures are intended to encourage
• explain the purpose of adopting economic value added (EVATM) as a
performance measure and the disadvantages that might result from
using it.
16.5 Case study
1. Read the case study ‘Industrial electronics, Inc.’ at the end of Merchant
and Van der Stede (2017) Chapter 10, p.421, then answer the
following questions:
• Using the new scheme, calculate the bonus award as a percentage
of base salary for the following five divisions as an example of the
performance of the company:
Division Budgeted
operating net
income
Budgeted
operating
assets
Actual
operating net
income
Actual
operating
assets
$,000 $,000 $,000 $,000
1 1,000 8,000 1,150 7,000
2 1,000 8,000 4,500 7,000
3 50 1000 300 800
4 (700) 3,000 (300) 4,200
5 600 1,000 100 1,800
• Discuss the advantages and problems of the current bonus system.
• Discuss the advantages and problems of proposed new system.
• Suggest ways in which the problems of the new system could be
overcome.
Chapter 16: Financial performance measures and their effects
167
16.6 Test your knowledge and understanding
1. Explain economic income and how it can be measured. Discuss
the advantages and problems of using this measure for divisional
performance appraisal.
2. Explain accounting income and how it can be measured. Discuss
the advantages and problems of using these measures for divisional
performance appraisal. You are not required to compare different
accounting measures (e.g. EBITDA, ROI, RI and EVA(™)).
Notes
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Chapter 17: Remedies to the myopia problem
169
Chapter 17: Remedies to the myopia
problem
17.1 Introduction
The word ‘myopia’ is the scientific term for short-sightedness. Its use is
appropriate here because, as we saw in the previous chapter, the main
accounting measures regularly used for results controls encourage a short-
sighted approach. This does not mean that managers are deliberately
acting against the economic objectives of the company at large.The
performance measures in place motivate managers to improve their own
performance (and therefore rewards) by making decisions that are not
necessarily in the organisation’s long-term interests.
The chapter broadly explores how top management would like managers
to behave and how results controls can be more effective.
17.1.1 Aim of the chapter
This chapter aims to:
• look at ways to improve performance measurement and align
managers’ decision-making more closely with corporate goals, by
encouraging managers to look to the future as well as the present.
17.1.2 Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, and you should be able to:
• explain the term ‘myopia’ and why managers may act myopically
• discuss the methods, advantages and difficulties of the following ways
of reducing myopia:
• reducing pressure on short-term profits
• controlling investment with pre-action reviews
• extending the measurement horizon
• measuring changes in value directly
• improving the accounting measures
• measuring a set of value drivers.
17.1.3 Essential reading
Merchant, K.A. and W.A. Van der Stede Management control systems:
Performance measurement, evaluation and incentives. (Harlow: Pearson,
2017) 4th edition [ISBN 9781292110554] Chapter 11.
17.2 Pressures to act myopically
All business people know that they need to focus on making activities that
are happening in the present really effective but also take actions that
build towards the future.
For example, a local hairdresser and the staff that work there are good at
their jobs and create a warm, welcoming atmosphere. The salon is busy.
The owner, however, chooses to have the salon completely refurbished,
despite the fact that the old furnishings are attractive and serviceable.
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When asked why they spent the money, they said, ‘Customers both existing
and especially new (who do not yet know how good our service is), want
to feel that we are ahead of fashion from the moment they walk in or see
our place on the internet. We pride ourselves on staying up to date with
techniques and styles, and our environment needs to reflect that’.
Looking after daily business while also looking forward by ensuring that
everyone is trained in new techniques and securing the right look for
the salon are all part of running the business. As this is the owner’s own
business, they will reap the benefits in the future.
Corporate managers, who are encouraged to attempt to show smooth
earnings growth and to meet stock market expectations are not motivated
to invest in the future. They are more likely to focus on ensuring that
current profits meet market expectations.
17.2.1 Gamesmanship
This is a type of behavioural displacement that was discussed in Chapter
12 of the subject guide. It is a way of ensuring that performance coincides
with stock market expectations by enhancing profits. Two suggested ways
are by:
1. reassessing reserves (e.g. bad debt provisions) and writing them back
to improve profits
2. selling financial assets at the right time for the profits from them to hit
the reported earnings.
Activity 17.1
Make notes on the section ‘Pressures to act myopically’ in Merchant and Van der Stede
(2017) Chapter 11. It illustrates gamesmanship (i.e. actions to deliberately smooth
earnings to meet stock market expectations).
Although smooth earnings growth is valued by investors, stock markets
also react favourably to announcements that indicate strategically
important investments are being made. Many companies attract investors
specifically because they show that investing in the future, particularly
in terms of innovation of products and/or markets and innovative new
production technologies, are among their future aims.
Activity 17.2
Read the examples of Amazon and IBM in the section ‘Pressures to act myopically’ in
Merchant and Van der Stede (2017) Chapter 11. Make notes identifying the differences
between the two companies and discuss these with other students on the VLE.
17.3 Ways to decrease myopia
17.3.1 Reduce pressures for short-term profit
Instead of placing the most weighting when calculating bonuses on
reaching demanding short-term profit targets, these weightings can be
reduced and more reward given to actions that improve the organisation’s
longer term prospects. Since these actions will vary according to the
situation, a totally formulaic response is probably unlikely. Merchant
and Van der Stede (2017) cite the example of Johnson and Johnson,
the healthcare and pharmaceuticals company, which reviews salary
and bonuses using a subjective, qualitative approach. This organisation
Chapter 17: Remedies to the myopia problem
171
seeks to reward effort and recognise unique performance. (We discussed
subjective appraisal in Chapter 15, section 15.5.2 of the subject guide.)
Alternatively, the short-term profit target itself can be made easier to
achieve, giving managers more time to work on longer term activities.
Usually some guidance and performance structure is needed to encourage
actions that are oriented to the future.
The limitations of this approach is that it may reduce managers’ focus on
short-term results without improving long-term performance. Managers
may need to use non-financial indicators.
Activity 17.3
Read the examples of sport in China and HSBC Bank in the section ‘Reduce pressures for
short-term profit’ in Merchant and Van der Stede (2017) Chapter 11. What problems did
they identify and how did they remedy them?
17.3.2 Control investment with pre-action reviews
This solution attempts to cope with the problems cited in the previous
chapter relating to accepting or rejecting investment opportunities.
Idea 1
This works by dividing the income statement into two parts. The top part
calculates short-term operating performance. Managers are appraised and
earn bonuses for maximising short-term operating income.
The costs of longer term investments are entered below the operating income
line. These costs relate to developmental expenses incurred to generate
revenues in the future. Managers can propose ideas for developmental
investments, indicating the expected pay-offs. These proposals are reviewed
in capital budgeting rounds and the outcomes are monitored.
Idea 2
In order to cushion lower level entities from the impact of developmental
expenses, some companies fund these expenses at higher organisational
levels until they begin to generate revenues.
Idea 3
Firms split themselves into ‘today businesses’ and ‘tomorrow businesses’.
The managers of the ‘today businesses’ are expected to focus on being
lean, efficient and competitive, leading to high net incomes. They are
monitored by tight financial controls. The ‘tomorrow businesses’ managers
focus on new business opportunities (e.g. products/markets). They are
monitored by non-financial performance indicators and action controls.
Activity 17.4
Read the example about Google in the section ‘Control investment with pre-action
reviews’ in Merchant and Van der Stede (2017) Chapter 11. Make notes or discuss with
other students on the VLE whether Google’s approach to innovation and its ease of
execution could similarly be adopted by a company selling tangible products.
Limitations
A clear distinction between developmental and operating expenditure
may not exist (e.g. manufacturing processes and market development
expenditure may benefit the present and the future). This requires
judgement as to whether expenditure is above or below the line. This can
encourage gaming by managers.
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Using this approach, the final decisions on which developmental
expenditure to fund are passed to corporate management who are less
well informed than entity managers about the prospects of each specific
entity and its funding needs. This could lead to poor quality resource
allocation decisions or corporate managers funding their own pet projects.
17.3.3 Extend the measurement horizon (use long-term incentives)
Merchant and Van der Stede (2017) base much of their discussion of
measurement horizon on the survey research ‘Changing practices in
executive compensation: long-term incentive plan design’ (Compensation
Advisory Partners 2015).
The idea of using long-term incentives is supported by Christine Lagarde of
the IMF and Fidelity, a top 10 shareholder in many FTSE 100 groups and
several European companies. You can read about their views in the section
‘Extend the measurement horizon’ in Merchant and Van der Stede (2017)
Chapter 11.
In Chapter 15 of the subject guide, we discussed the use of stock options
and/or performance targets over three to five years. The survey indicates
that companies are de-emphasising stock options in favour of performance
targets such as return on investment (ROI), total shareholder return (TSR)
and earnings per share (EPS). It also reports that most companies use
more than one measure, with TSR being the most popular.
Not surprisingly, the long-term incentives that most companies choose to
adopt are the key measures of success in their industry. Companies mostly
use internal goals and an external benchmark (e.g. a peer group).
Problems with long-term incentives
Using long-term incentives to reward managers can be expensive as
managers prefer short-term bonuses. This is partly because short-term
targets are more likely to be achieved and also because this means that
bonuses may be paid more frequently. The unpopularity of long-term
incentives is reflected in the fact that managers apply a high discount of
more than 50% to deferred bonuses. This means that if they are not at
least twice as generous as short-term bonuses, managers will continue to
focus on short-term performance.
A way around this problem is to pay bonuses for annual performance, but
claw them back if future performance suffers.
Long-term performance targets can be set by basing them on the
numbers included in the long-term strategic plan, which is developed
with the advice of senior managers. However, a consequence may be that
innovation is stifled for fear that new ideas will not succeed. This leads
managers to make conservative estimates, which is not an ideal situation
for an ambitious, forward-looking company.
17.3.4 Measure changes in value directly
This approach looks at using economic income for each division in an
organisation. In this case, it is not measured by changes in the stock market
valuation. For each division, economic income is calculated by measuring
the discounted future cash flows that the division will generate in the
future with the existing net assets. This is done at the beginning and end of
the measurement period, using an appropriate discount factor.
Limitations
It is very difficult to know how the market, innovations and so on will
change over the years, so estimates are likely to be unreliable, which
Chapter 17: Remedies to the myopia problem
173
calls into question the feasibility of this approach. Who will make the
estimates? If the manager to be rewarded prepares the estimates, there is
an obvious motivation to bias them.
The estimates could be checked by an outsider (e.g. an auditor), but
that person would need an in-depth knowledge about the company, the
specifics about what is being estimated and the future strategic focus of
the company. This would also be very expensive.
17.3.5 Improve the accounting measures
The suggestions below include several that have been mentioned in earlier
chapters, so this section provides a summary of those points and mentions
others. It is likely that adopting these measures would involve deviating
from financial accounting rules and maintaining a separate set of records.
However, this is commonplace for tax purposes and is implied by the
concept of EVATM, so it is unlikely to be too much of a problem as data
processing is straightforward these days.
Suggestions include:
• Choose depreciable lives for assets which coincide with their economic
lives (not the conservatively short period used by many companies).
• Charge depreciation on the use of older assets which have been fully
depreciated to recognise the continued use of the asset and prompt the
need for replacements (since the asset can no longer be regarded as a
free resource).
• Capitalise all expenditure required to generate future cash flows (e.g.
R&D, customer acquisition, employee development). These should
then become expenses in future periods as the revenues arise.
• Capitalise all leases, not just finance leases.
• Recognise value changes as they arise rather than waiting for the
completion of a transaction (e.g. the mark-to-market basis could be
used). This holds assets in the balance sheet at market value enabling
profits or losses to be recognised when they occur, not just when
the asset is sold. Oil and gas companies recognise value when a
commodity is discovered rather than when it is sold.
• Charge an imputed cost of equity capital as well as debt interest.
17.3.6 Measure a set of value drivers
This approach moves away from just relying on financial measures and
incorporates a number of the lead activities that have already been
discussed. These value drivers are not measured in financial terms but by
count or percentage.
The expectation is that in each responsibility area a group of measures will
be put together to encourage managers to be aware of, and be rewarded
for, a wider range of activities that improve performance in the short and
long term.
There are several different models that can be used to provide an
appropriate range of financial and non-financial measures. Any model
would need to be adjusted to the needs of a particular company.
The most famous value driver is the balanced scorecard developed by
Kaplan and Norton. It proposes the following structure, which looks at
achievement from four perspectives:
• Financial: With a shareholder focus (or other more appropriate
name in the public sector), this perspective looks at organisational
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financial performance and the use of financial resources. Measures
include: operating income, margins, return on equity and meeting
budgetary targets.
• Customer/stakeholder: This operates from the point of view of the
customer or other key stakeholders that the organisation is designed
to serve. Measures include delivery targets, customer services and
complaints, and percentage sales from new products.
• Internal processes: Here organisations run a tight ship by looking
at quality and efficiency relating to products, services or other key
business processes. Measures include cycle times, yield, quality
measures, efficiency and effectiveness.
• Organisational capacity (originally called learning and
growth): Organisational performance is viewed through the lenses
of developing staff training, improving infrastructure and technology,
new product development and other capacities that are key to a
breakthrough performance.
17.3.7 History of performance measures
Although the balanced scorecard and other models formalised the
incorporation of non-financial measures in organisations, the idea has
been practised in different ways by companies, particularly non-profit
organisations, for many years.
17.4 Strengths of several performance measures
Performance measures aim to make managers aware of leading activities
which result in future profits. In some cases these may be activities to
which managers have not previously given much attention. This focus
creates a feed-forward control mechanism for emphasising activities with
future impacts.
It is important that measures are chosen carefully to prompt managers to
focus on areas which, if ignored, could lead to a poor performance in the
future. It balances short- and long-term goals.
As well as focusing on non-financial measures, the scorecard and other
methods encourage the disaggregation of financial figures which tend
otherwise to be presented in summary form. Examples include sales of
new products and/or identifying new customers or new regions; cost of
training, maintenance and machine upgrading; and product research and
development, so that they can be looked at in more detail.
The approach fits in well with the stakeholder view of the company.
Financial measures focus mostly on the needs of shareholders. Concerns of
other stakeholders (e.g. employees, customers, suppliers, conservationists
and society at large) can be monitored using other measures.
It helps managers to understand the importance of each activity being
measured as this is part of increasing the value of entities.
The system works best if the measures cover the activities that matter most
to the particular company. This involves the development of strategy maps
that can identify the actions needed to pursue future strategy. The ways in
which these actions will impact on the activities of different divisions and
their managers must be determined in detail.
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17.5 Issues in creating the correct measures
The first step is to identify the activities that make a difference in the
organisation and measure these. For example, a fast food company was
concerned about staff turnover in its branches. They found that general
staff turnover was not a problem for the success of each branch, but that
supervisory staff turnover was.
Some measures will be subjective (e.g. employee morale). In this
case, managers must decide how they are to be measured. Simplistic
measurement can lead to inappropriate behaviour. For example, requiring
departments to provide a certain number of hours of employee training
could lead to employees being sent on unnecessary courses simply to
meet the target. Identifying the ways in which training has improved the
effectiveness of employees is a better measure.
The effectiveness of customers’ experience could be measured by, for
example, customer turnover, mystery shoppers or customer surveys.
The type and number of measures used to define performance will vary,
depending on the responsibilities of the manager. They should be targeted
at the activities that are relevant to that responsibility area and will be
weighted as to their importance.
Sometimes the measures can reduce effectiveness if they are not carefully
implemented. For example, attempting to meet customer satisfaction
targets can mean that more time is spent on each customer than is strictly
necessary which will reduce the throughput of customers, with a resultant
loss of sales.
Pay-off relationships may not be linear, and once a particular level has
been reached, putting in more effort may be unnecessary and wasteful, for
example in terms of customer satisfaction.
These performance measurement systems can be expensive to implement,
especially if they include consultants’ fees, and will need to be refreshed
regularly to keep them relevant.
17.6 Reminder of learning outcomes
Having completed this chapter, and the Essential reading and activities,
you should be able to:
• explain the term ‘myopia’ and why managers may act myopically
• discuss the methods, advantages and difficulties of the following ways
of reducing myopia:
• reducing pressure on short-term profits
• controlling investment with pre-action reviews
• extending the measurement horizon
• measuring changes in value directly
• improving the accounting measures
• measuring a set of value drivers.
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17.7 Case study
1. Read the case study ‘Mainfreight’ at the end of Merchant and Van der
Stede (2017) Chapter 11, pp.488–500, then answer the following
questions:
• Mainfreight’s top executives (three of whom are qualified
accountants) maintain that their company does not prepare
budgets. Is this an accurate statement? How does one determine
whether a company prepares a budget or not?
At the very least Mainfreight’s management system is not traditional:
• What are the key elements of Mainfreight’s results control system?
• Why did Mainfreight’s managers decide to take a non-traditional
approach?
• How does Mainfreight perform the functions typically fulfilled by
budgets? Are some of these functions not really that important?
• Does the Mainfreight system address some of the limitations of
traditional budgets? Does it introduce new limitations?
• Is Mainfreight a well-controlled organisation?
• Should companies which currently run budgeting systems adopt
some of Mainfreight’s type of systems?
17.8 Test your knowledge and understanding
1. Identify three methods of reducing managers’ focus on short-term
profits. Explain how each method would work and its advantages and
limitations.
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177
Chapter 18: Using financial
results controls in the presence of
uncontrollable factors
18.1 Introduction
Uncontrollable factors are a part of life and their effect on businesses
can be substantial. They are the reason for the existence of the insurance
industry. However, many activities are not covered by insurance or are too
expensive to cover. For example, it may be possible for an airline to insure
against flight disruption due to an event like the Icelandic volcano, but
it would be unlikely that an oil company would be able to insure against
tumbling oil prices.
There are many, much smaller, uncontrollable factors that happen
regularly, for example customers going bankrupt or cancelling a big order,
closing a factory due to strikes, breakdown of transport links to bring
materials to the company or dispatch goods from the company.
On the positive side, unexpected excellent weather may lead to better
crops or a bankrupt competitor may open up the market to higher sales.
The big question is: should individual managers be held responsible for
the impact of these events when it comes to their performance appraisal?
18.1.1. Aim of the chapter
This chapter aims to:
• address the issue of the extent to which managers should be held
accountable for factors that are outside their control.
18.1.2 Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• explain the controllability principle and give examples of types of
uncontrollable factors
• describe the actions that can be taken to control for the distorting
effects of uncontrollable factors before the measurement period
• discuss the ways in which the distorting effects of uncontrollable
factors can be measured
• outline the advantages and problems of using subjective evaluations
where there are uncontrollable factors.
18.1.3 Essential reading
Merchant, K.A. and W.A. Van der Stede Management control systems:
Performance measurement, evaluation and incentives. (Harlow: Pearson,
2017) 4th edition [ISBN 9781292110554] Chapter 12.
18.2 The controllability principle
This states that a manager should only be held responsible for aspects of
a business that they can control. This means that managers do not have to
take responsibility for factors that cannot be predicted and are therefore
outside their control. This would apply to both losses and gains.
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However, the role of a manager is to use judgement to manage their area
of the business, so it would be reasonable to expect that they would take
all possible steps before the event to protect against the impact of disasters
and maximise the effects of gains. After the event, action should be taken
to mitigate any loss or maximise any opportunity.
It is in the organisation’s best interests not to expect managers to bear
uncontrollable risk because it encourages them to be risk averse. They
will manage in ways that reduce risk, for example by not accepting risky
investments or customers whose financial track record is not perfect. Also,
if they are expected to be accountable for uncontrollable risk, they will
expect much higher salaries. Managers may also ‘gameplay’ by managing
earnings or creating budgetary slack to protect their results from unforeseen
problems. Managers will also waste time and effort finding excuses as to
why these uncontrollable events should not be included their performance.
In fairness, responsibility for these uncontrollable events tends to lie more
with the owners (shareholders) who are the risk takers rather than with
subordinate managers.
Activity 18.1
Using information in the section ‘The controllability principle’ in Merchant and Van der
Stede (2017) Chapter 12, or from other sources, explain the circumstances that influence
the level of a manager’s attitude to risk.
18.3 Deciding on whether factors are uncontrollable
18.3.1 Economic and competitive factors
Examples of these are changes in: consumer preferences, demand, prices
of products or services, input prices, labour cost and exchange rate
fluctuations.
This is the most difficult area to assess when deciding whether factors
are controllable or not, because part of a manager’s role is to predict and
respond to variables in trading by, for example, changing an advertising
campaign or running promotions to stimulate demand, redesigning
products, looking for cheaper suppliers or helping employees to be more
productive.
On the whole, companies do not consider making these changes. However,
in some cases an aspect that affects many parts of a business may call
for central intervention (e.g. corporate hedging to mitigate raw material
prices), so will be uncontrollable by the manager.
18.3.2 Force majeure (act of nature or act of God)
Examples of these are one-off, unexpected events like a severe natural
disaster (e.g. hurricanes, earthquakes, floods) or exceptional events like
those involving riots, terrorism, serious illness or death of key executives,
fires and severe installation breakdowns. These tend to be disasters for
most firms but are bonanzas for the companies that are commissioned to
respond and make good after the disaster (e.g. construction companies,
storage facilities, staff temping offices, hotels).
Most companies will protect managers from the downside risk of these
events as long as there is evidence that the manager has taken all possible
actions to mitigate the effect of the disaster.
Managers cannot avoid the disaster, but subsequently they can act to save
money and the company’s reputation.
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Activity 18.2
Using information from the section ‘Types of uncontrollable factors’ from Merchant and
Van der Stede (2017) Chapter 12, and/or other sources, make notes of the actions that
some companies have taken to save money or maintain their operating ability despite
force majeure. Discuss your notes with other students on the VLE.
18.3.3 Interdependence
Pooled interdependence
This is a situation where the division is affected by the actions of other
divisions in the company because they use shared resources (e.g. corporate
staff activities such as shared human resources support). Is it fair for
divisions to be affected by the poor performance of these services?
In many organisations this is dealt with by an agreed contract between
the divisions and the corporate service, set at the annual budgeting stage
in relation to the services to be provided and the associated costs. This
protects the divisions against cost increases, but not from poor service
from these corporate services.
Sequential and reciprocal interdependence
This arises where one division is dependent on the work of another
division (sequential) or both provide work to or receive work from other
divisions (reciprocal).
This is mostly dealt with by the use of transfer prices.
18.3.4 Interventions from higher management
These actions essentially take away the autonomy of the divisional
manager. Examples include:
• dictating a specific transfer price which assists tax minimisation or
funds repatriation
• stating that the division should sell to a particular customer at a lower
than normal price because other benefits will accrue to different
divisions in the organisation
• not approving decisions initiated by the divisional manager (e.g.
proposed expenditure, changes to production schedules).
18.4 Controlling for the distorting effects of
uncontrollables
There are two complementary activities that can be incorporated, before
and after the measurement period.
18.4.1 Before the measurement period
It is necessary to define the items that the manager can control or have
influence over, set results measures accordingly and take any other
necessary measures. Examples of the other measures are listed below.
Insurance
Many events can be insured against (e.g. physical damage to company
property, damage caused by employees, employee error, vandalism, riots,
theft, product liability).
Design of responsibility structures
The general rule is that the divisional manager will be accountable for
the costs and revenues that they can control. In terms of the income
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statement, the top section can identify controllable revenues and cost
and therefore controllable income can be calculated. Non-controllable
divisional expenses and allocated central expenses are then deducted to
calculate net income.
Some companies may also include, as controllable, costs they wish
the manager to be aware of or pay attention to. This often occurs with
corporate overheads (e.g. personnel costs, information systems costs).
This may be considered correct for two reasons. First, the manager would
have to incur these costs if they were running their own business and may
need the information as a guide to the prices and volume of sales needed
to make target profits. Secondly, the divisional manager can put pressure
on the corporate departments to control costs and provide competitive
services. Taken to its logical conclusion, this should mean that divisions
could also buy the resources in from outside. Whether or not to allow this
would also be a corporate decision. This indicates that to a certain extent
these costs are controllable by the divisional manager.
It is unwise to expect managers to be charged with responsibility for too
many things over which they have too little control.
Contingency scenario planning
In uncertain environments, this activity encourages managers to build
in contingency planning for possible outcomes and therefore to be
prepared to change their plans if necessary. However, it is more costly
than just preparing for one scenario. Companies need to estimate whether
it is sufficiently likely that their organisation will be caught up in the
contingency that has been forecast.
Updating plans more frequently
If there are considerable future uncertainties, using rolling budgets may
be a useful practice. This is because the standards set to create plans are
more likely to become out of date as time goes by and any contingencies
can be reviewed closer to the time they might be expected to happen.
Since standards become less relevant over time, it may be fairer to review
managerial performance monthly or quarterly rather than (or as well as)
yearly. The disadvantages are the expense of more regular reviews and the
fact that in a shorter time period the outcome of some of the manager’s
decisions may not be reflected (e.g. a sales push may have incurred cost
but not yet resulted in higher sales). (This relates to the issues discussed in
Chapter 17 of the subject guide on extending the measurement horizon.)
18.4.2 After the measurement period
If the uncontrollable event occurs during a measurement period, the
financial impact of the event must be adjusted for before rewards can be
assigned. These adjustments may be done objectively through calculations
or subjectively through an evaluator’s judgement.
18.5 Methods which can be used to determine the
impact of the event
18.5.1 Variance analysis
As well as the normal price, volume, cost and usage variances, other
aspects relevant to particular external factors, which are controllable
either by those factors or the behaviour of other divisions, can be isolated.
Merchant and Van der Stede (2017) identify sales performance which
can be measured against industry volume, market share, sales price and
exchange rate.
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Activity 18.3
Look at Tables 12.2–12.3 in Merchant and Van der Stede (2017) Chapter 12. Make a
note of which variances are considered to be the responsibility of the trading division.
Make up an example of your own.
18.5.2 Flexible performance standards
The aim here is to adjust the monetary figures for events that are outside
the manager’s control by, for example, recalculating the budget to reflect
current exchange rates or making large changes in input prices (such as
adjusting for oil price changes). However, this is only likely to be done if
the manager has no way of avoiding the change by using other materials
or processes to mitigate the effects. Of course, a favourable price should
also be considered if these are also outside the manager’s control.
18.5.3 Relative performance evaluations
This method does not appraise and reward the managers on the absolute
level of results but in relation to a peer group. This can help deal with
the effects of uncontrollable factors that affect the members of a peer
group. The peer group can be other branches of the company or outside
competitors with similar characteristics (e.g. bank branches, fast food
chains).
Activity 18.4
Read the example of Domino’s Pizza in the section ‘Relative performance evaluations’ in
Merchant and Van der Stede (2017) Chapter 12. Make notes of how the results could be
adjusted for these factors and discuss these with other students on the VLE.
Although relative performance evaluation is not possible in many types of
organisation, some reference to industry performance can be included. The
purpose of this would be either to change targets or as part of a subjective
evaluation.
18.5.4 Subjective performance evaluations
Subjective performance evaluations are done by higher management and
are intended to take into account all aspects of performance, including
uncontrollable events. Instead of using formal calculations, the assessor
judges whether the results are strong or weak. These evaluations can be
useful in correcting flaws in the results measures. The evaluator can take
into account other issues.
The problems with subjective performance evaluations are that the
evaluator has power over the manager, which may create resentment. In
addition, biases may occur, including:
• Outcome effect bias: where the evaluator brings in knowledge of other
results that may not have a bearing on the manager’s performance.
• Hindsight effect bias: where evaluators assume that knowledge that
was only discovered later was available to the manager at the time
decisions were made. It appears to the evaluator that events were
more controllable than was, in fact, the case.
• Deterring learning and motivation: The evaluator may not give much
feedback on how bonuses were derived. This deters learning and
demotivates the manager being evaluated.
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• Managers may not trust the evaluation if evaluators have failed
to honour rewards or promises made previously. This also affects
motivation and morale.
Subjective evaluations can lead to an excuse culture. In psychology, this is
termed ‘attribution theory’, whereby people attribute success to their own
efforts, abilities and skills, and failure to factors outside their control (e.g.
bad luck, the difficulty of the task or other external factors). Thus they
make excuses instead of learning from their mistakes. They tend not to
focus on achieving targets as much as finding excuses. They may appeal
against their evaluation, thus using energy that could be better directed to
performing better.
Subjective evaluations, if done well, will involve the evaluator taking
considerable time to understand the situations faced by the manager
during the period under scrutiny. They have to consider the extent to
which results were due to effort and to which they were due to good or
bad external effects. This may be a cause of resentment for the manager.
Activity 18.5
Imagine you are an assessor. Make notes of the steps you would take to decide how well
a manager had achieved their targets. Discuss your notes with other students on the VLE.
18.6 Reminder of learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• explain the controllability principle and give examples of types of
uncontrollable factors
• describe the actions that can be taken to control for the distorting
effects of uncontrollable factors before the measurement period
• discuss the ways in which the distorting effects of uncontrollable
factors can be measured
• outline the advantages and problems of using subjective evaluations
where there are uncontrollable factors.
18.7 Case study
1. Read the case study ‘Olympic Car Wash’ at the end of Merchant
and Van der Stede (2017) Chapter 12, pp.531–32, then answer the
following questions:
• How large should the bonus pool be for the Aalst location?
• Since Aalst actually made a loss (and possibly other locations did
too), can the company afford this level of bonus?
• Is the rain the only reason for lower sales? What other reasons
could there be which might be within the manager’s control?
• Does the method used encourage staff to welcome the rain? Could
they offer other services that are not rain dependent?
18.8 Test your knowledge and understanding
1. Describe the purpose of adjusting managers’ performance for
uncontrollable events.
2. Explain situations where subjective evaluation is likely to be used.
3. Explain possible difficulties with this approach.
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Chapter 19: Management control-related
ethical issues
19.1 Introduction
Ethics provide a good guide to how employees throughout an organisation
should behave. It is important that a company’s code of ethics is followed
by workers at different levels and is also adhered to by upper and top
management. Ethics are a key part of cultural and personnel controls and
can augment action and results controls.
Basic economics assumes that rational people will act to maximise their
own self-interest and that the purpose of for-profit organisations is to
maximise value for shareholders. These assumptions are too simplistic
and ignore the fact that people live and work within the community of
the company and that organisations have many stakeholders as well
as shareholders. Ethical individuals will consider how their behaviour
impacts on other stakeholders (e.g. other employees, suppliers, customers,
the local community and the environment).
However, doing the right thing does not always lead to better rewards.
There is a tension between selfishness and doing the right thing. Those
who behave unethically often benefit financially and those who do the
right thing can earn lower bonuses. Whistleblowers who bring unethical
behaviour into the public domain can be dismissed or demoted, although
some countries have passed laws protecting the rights of such employees.
19.1.1 Aim of the chapter
This chapter aims to:
• outline the importance of ethics in organisations and the issues faced
by them when introducing and using ethical controls.
19.1.2 Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• explain the purposes of having ethical codes for professional
organisations
• describe how ethical codes are used in companies
• identify four ethical models and explain how they might be used in
companies
• discuss the ethical issues of creating budgetary slack
• explain how good ethics should be disseminated throughout an
organisation.
19.1.3 Essential reading
Merchant K.A. and W.A. Van der Stede Management control systems:
Performance measurement, evaluation and incentives. (Harlow: Pearson,
2017) 4th edition [ISBN 9781292110554] Chapter 15.
19.1.4 Further reading
Association of Chartered Accountants (ACCA) ‘ACCA code of conduct and
ethics’, ACCA www.accaglobal.com/uk/en/member/standards/ethics/acca-
code-of-ethics-and-conduct.html
https://www.accaglobal.com/uk/en/member/standards/ethics/acca-code-of-ethics-and-conduct.html
https://www.accaglobal.com/uk/en/member/standards/ethics/acca-code-of-ethics-and-conduct.html
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Birsch, D. and J.H. Fielder The Ford Pinto case: a study in applied ethics, business
and society. (Albany, NY: State University of New York Press, 1994) [ISBN
9780791422342].
UK Government ‘Whistleblowing for employees’, GOV.UK www.gov.uk/
whistleblowing/who-to-tell-what-to-expect
19.2 Ethical behaviour in a business context
Governments and organisations pass laws or have rules to deter unethical
behaviour; however, these cannot be watertight and cover all possible
situations. So ethical standards attempt to fill the gaps. There are
nevertheless situations where, through collusion, unethical behaviour
occurs and can be encouraged within a group, which can lead to ethical
drift. For example, directors and managers who are in sufficiently high
positions to affect reported results may be tempted to do so.
Activity 19.1
Read the details of LIBOR and Tesco’s financial reporting in the section ‘Good ethical
analyses and their importance’ in Merchant and Van der Stede (2017) Chapter 15. Note
down ways in which this could have been avoided and discuss them with other students
on the VLE.
19.2.1 Professional ethics
Most professional bodies expect their members to maintain a code of
professional ethics. Part of a professional body’s role is to monitor the
behaviour of their members and to take disciplinary action if necessary,
in order to protect the reputation of all members. You can read advice for
whistleblowers at: www.gov.uk/whistleblowing/who-to-tell-what-to-expect
and the ACCA code of ethics at: www.accaglobal.com/uk/en/member/
standards/ethics/acca-code-of-ethics-and-conduct.html
19.2.2 Providing example and giving training
Company managers should have policies, rules, checks and balances,
measurement systems, rewards and specific ethical policies in place. In
addition, they should lead by example and provide training sessions, sets
of values and codes of conduct to help employees identify and assess
ethical issues.
19.3 Ethical models
Ethics is about how actions affect the interests of other people. There are
four main theoretical models. However, as we are mostly interested in
management controls in this chapter, we will not go into details about
the models, but will highlight the ways in which they affect management
decision- making and control.
19.3.1 Utilitarianism
The consequences of an action are judged in terms of welfare economics
and cost-benefit analysis. The objective is to act in a way that creates
the greatest good for the greatest number of people affected by the
action. A clear example in business was when, in the 1970s, the Ford
Motor Company discovered a fault in the petrol tank of their Pinto cars
which could result in a fire if the car was involved in a rear-end collision.
Nevertheless, they did not recall the 11 million cars affected for a refit. As
a result, several people died in horrifying accidents. Clearly, their cost-
benefit analysis model did not place a high enough value on human life.
https://www.gov.uk/whistleblowing/who-to-tell-what-to-expect
https://www.gov.uk/whistleblowing/who-to-tell-what-to-expect
https://www.gov.uk/whistleblowing/who-to-tell-what-to-expect
http://www.accaglobal.com/uk/en/member/standards/ethics/acca-code-of-ethics-and-conduct.html
http://www.accaglobal.com/uk/en/member/standards/ethics/acca-code-of-ethics-and-conduct.html
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19.3.2 Rights and duties
This model identifies the basic rights that people have and the duty they
have to uphold similar rights for others.
In a management context, many of these rights and duties are identified
in contracts and job descriptions. Often, these are challenged by unions
or other worker groups if they seem unfair. This implies that a balance
of power exists within an organisation and this creates its own ethical
dilemmas.
Within the workplace, many rights and duties may be covered by the idea
that employees have the right to be treated politely, not be bullied and so
on.
19.3.3 Justice/fairness
This approach considers that processes should be fair even if outcomes
are not: for example, most people do not object to a rich person winning
a lottery if the process is transparent. In a business context, this indicates
that pay and performance packages should be seen to be fair.
19.3.4 Virtues
This model regards morals to be rooted in virtues (e.g. integrity, loyalty,
courage and, possibly, generosity, grace, decency, commitment, idealism
among many others). These can be built into the personnel and cultural
controls of an organisation. It is important that a company has a code of
ethics to which management and employees can refer if there are disputes
over behaviour. Even if the ethical behaviour guidelines are part of an
employment contract, it is also necessary to have action controls to ensure
that the behaviour of staff falls within the guidelines.
19.4 Analysing ethical issues
If there is a situation in which a person or group appears to have behaved
unethically, the company should ensure that there is a system for
investigating and deciding on the next steps.
The method could follow these steps:
• Clarify the facts.
• Define the ethical issue.
• Specify the alternative courses of action.
• Compare values and alternatives.
• Assess the consequences.
• Make a decision.
Activity 19.2
Imagine an unethical situation that has occurred (in a college, club or business) and apply
the above method to analyse and resolve the issue.
Due to the somewhat ephemeral nature of ethical concepts, different
people may come to different conclusions about a situation. It is important
that managers keep an open mind and are aware of different views when
handling issues of an ethical nature.
It must be made clear that there is a difference between acting unethically
and acting fraudulently. If fraud has occurred, the guilty party will be
dealt with through prosecution. However, many areas of behaviour are not
AC3193 Accounting theory
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covered by the law, so ethical behaviour within an organisation is expected
in order to ensure that there is fairness and efficiency.
19.5 Some management control-related ethical issues
19.5.1 The ethics of creating budgetary slack
This occurs where managers are held accountable for their department’s
performance. In particular, this is relevant where meeting or exceeding
performance targets impacts on receiving bonuses, salary rises or
promotions.
In this situation, the department manager is using their superior
knowledge of the operation of the department in order to draw up such
a budget. It results in targets that are easier to achieve and therefore
bonuses will result.
This could be regarded as unethical as it means that the manager does not
have to work as hard, which results in lower profitability for shareholders.
It can also lead to undesirable behaviour such as splashing out on
unnecessary items to meet the budget spend so that next year’s budget will
not be reduced. Higher level managers will use the budget estimates for
their own aggregated estimates when considering resource allocation and
investment decisions.
However, the creation of slack can be justified by managers who regard
it as protecting themselves against the uncertainty of the future that they
have to deal with. This is useful in companies who consider the budgetary
commitment as a ‘hard promise’ which, if not kept, will result in penalties.
It can be regarded as a reasonable reaction to the imbalance that exists
between lower and higher management, and can be considered as part of
the budgetary negotiation process.
Activity 19.3
Read the section ‘The ethics of creating budgetary slack’ in Merchant and Van der Stede
(2017) Chapter 15. Make notes on the factors to take into account when deciding
whether creating slack is ethical in a particular company, and discuss these with other
students on the VLE.
19.5.2 The ethics of managing earnings
This activity uses either accounting methods or operating methods to
report a company’s earnings that are in line with expectations (e.g.
boosting earnings, smoothing earnings or saving earnings to boost future
results).
Accounting rules, professional ethics and corporate law all consider
this to be, at least, unethical and, possibly, illegal since it goes against
the disclosure of information that directors are required to pass on to
investors. There is massive asymmetry of information between directors
and investors, and therefore audited reports are the only way to discover
a company’s true financial position. Large shareholders may be able
to acquire information and may be able to influence board members.
However, smaller shareholders or potential investors do not have this
option, and therefore the auditors’ role is vital.
Chapter 19: Management control-related ethical issues
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Activity 19.4
Read the section ‘The ethics of managing earnings’ in Merchant and Van der Stede (2017)
Chapter 15, which discusses areas where directors might feel that earnings should be
‘managed’.
Make notes of your views and discuss these with other students on the VLE.
19.5.3 The ethics of responding to flawed control indicators
This situation occurs where an employee’s job is defined by action
controls. They notice that there are more effective ways to work, but
do not mention this and continue on in the way they were originally
instructed. For example, a maintenance worker who is required to
maintain certain machines on a monthly basis may notice that some
parts in a particular type of machine often wear out and need replacing
before the month end, so production has to be stopped in that area. The
maintenance worker may not feel it is their responsibility to bring this
issue to the notice of their supervisor.
This issue is more serious where those with higher responsibility,
particularly in the finance area, can see ways in which they could take
action to improve processes or security. Many finance professionals
are required by their professional bodies to be proactive in helping
organisations to avoid financial disaster if they become aware of a problem.
However, many managers and employees are not bound by such codes.
19.5.6 The ethics of using control indicators that are too good
The existence of computer surveillance which can monitor an employee’s
every move is now technically possible. An issue to consider is whether
there is a conflict between an employer’s right to monitor and an
employee’s right to autonomy, privacy and not to be subject to oppressive
controls (which amount to them working in electronic workshops).
Activity 19.5
Make notes on an employee’s and an employer’s point of view of what each party might
consider to be fair rules in the use of electronic surveillance. The section ‘The ethics of
using control indicators that are too good’ in Merchant and Van der Stede (2017) Chapter
15 makes some suggestions.
19.5.7 Spreading good ethics within the organisation
When companies are small and all employees can relate with the owner,
the role model provided by that person is usually the reference point for
the company’s ethics. Larger companies must develop formalised ethics
programmes with a set of values that the company expects the employees
to conform to. These will evolve into policy manuals, codes of ethics or
codes of conduct.
The codes may include specific guidelines (e.g. gifts from clients should
not be accepted) as well as some that are more general and indicate the
values that employees should uphold.
There should also be training programmes giving employees the
opportunity to discuss scenarios that might arise. The safeguarding of
children and vulnerable adults is a topical example of an area that might
be covered. Actions to be taken and who to go to for advice must be
clearly spelled out.
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Employees may be required to sign up to agree that they will uphold the
company’s code of conduct. It may be necessary to run refresher courses as
new areas are developed. This, of course, would lead to it being necessary
for employees to sign a new agreement that incorporates the changes.
Good practice from those at the top of the organisation is essential. If
this is not apparent, then those lower down the organisation will not
feel obliged to adhere to the code either. Monitoring should be done by
superiors and colleagues, although group norms also play a role here.
There should be a procedure for investigating issues and setting sanctions.
There should also be an ombudsman to represent those employees who
encounter ethical issues.
19.6 Reminder of learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• explain the purposes of having ethical codes for professional
organisations
• describe how ethical codes are used in companies
• identify four ethical models and explain how they might be used in
companies
• discuss the ethical issues of creating budgetary slack
• explain how good ethics should be disseminated throughout an
organisation.
19.7 Case study
1. Read the case study ‘Two budget targets’ at the end of Merchant and
Van der Stede (2017) Chapter 15, p.694, then answer the following
questions:
• Determine the facts.
• Define the ethical issues by identifying the stakeholders and listing
who benefits and who is harmed.
• How might Joe’s superiors act if they discovered what was
happening?
19.8 Test your knowledge and understanding
1. Identify the different levels of responsibility in a typical public limited
company. Explain one ethical issue an employee at each level may
face, why the issue has arisen and which checks may be in place to
help employees to act ethically.
Chapter 20: Management control in not-for-profit organisations
189
Chapter 20: Management control in
not-for-profit organisations
20.1 Introduction
In this chapter we will look at how control systems can be applied to
not-for-profit organisations. This can be difficult because the objectives of
these organisations are not focused on profit making (although, in order to
meet their goals, they must stay financially solvent). They must therefore
identify exactly what their goals are in order to convey them to their
employees. They must identify the tasks that employees must carry out
in order to meet the organisation’s goals as well as the measures that will
indicate how well tasks have been completed.
20.1.1 Aim of the chapter
This chapter aims to:
• provide a brief summary of how management control can be used in
not-for-profit organisations.
20.1.2 Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• identify different types of not-for-profit organisation and give
examples of the main types
• explain the main similarities and differences between for-profit and
not-for-profit organisations
• discuss ways in which public sector outputs can be identified and
measured
• explain fund accounting
• identify the ways in which public sector employment may differ from
that in the private sector.
20.1.3 Essential reading
Merchant, K.A. and W.A. Van der Stede Management control systems:
Performance measurement, evaluation and incentives. (Harlow: Pearson,
2017) 4th edition [ISBN 9781292110554] Chapter 16.
20.1.4 Further reading
Moullin, M. ‘How the public sector scorecard works’, Public sector scorecard
www.publicsectorscorecard.co.uk/how-the-pss-works.html
Office for National Statistics www.ons.gov.uk
20.2 Types of not-for-profit organisation
To clarify the kinds of organisations that fall into this category, we have
divided them into different groups.
20.2.1 Public sector organisations
These are either:
• national government-commissioned bodies, financed by taxation,
and include those running the government (e.g. the civil service, law
enforcement, defence, health, education, transport)
http://www.publicsectorscorecard.co.uk/how-the-pss-works.html
http://www.ons.gov.uk
AC3193 Accounting theory
190
• local authorities, which are responsible for services in a particular
region (e.g. refuse collection, road maintenance, public health,
education, planning).
In the UK in 2018, these large organisations employed nearly 7 million
people, approximately 16% of the working population (www.ons.gov.uk).
They provide a public good, which means that although every person
or household pays for the services they provide, no one can claim that a
specific part belongs to them. Therefore although the stakeholders are
the citizens and users of the services, they are only empowered to change
things through personal complaints, voting, petitions and the media. In
the private sector, by comparison, each customer has a defined product or
service and can receive redress if there is a fault.
20.2.2 Professional associations
These are set up to protect members and be a voice for them. They often
restrict membership to those who have attained certain qualifications
and, once admitted, members must adhere to a code of ethics. Annual
membership fees are levied and used for representing and protecting the
rights of members. Professional insurance may also be provided and the
association may also fund research (e.g. the British Medical Association).
These associations are usually run by appointed executives. The main
stakeholders are the members. Employer organisations also benefit
from the reassurance that their employees are governed by a code of
professional ethics.
20.2.3 Clubs
These are usually interest groups that use their membership subscription
to fund their interest (e.g. amateur football clubs, drama groups, etc.). The
main stakeholders are the members.
20.2.4 Charities
These are organisations set up with specific charitable objectives. They
can be very large and operate in many parts of the world (e.g. Oxfam,
Greenpeace) or have a local purpose (e.g. universities, hospitals,
museums). Small local charities may be set up to achieve a particular
purpose (e.g. a fund set up to help with or commemorate a particular
tragedy). In the UK, all charities with an income above £5,000 must be
registered with the Charities Commission, must state their charitable
purpose and must name their responsible officers. They also need to
make their financial accounts available annually. As they are funded by
donations, their stakeholders are their donors and the beneficiaries.
Activity 20.1
Use the internet to find out more about the organisational structure of a government
department, association or charity of your choice. On the VLE, see if other students have
chosen a different one from you, and compare your findings with them.
http://www.ons.gov.uk
Chapter 20: Management control in not-for-profit organisations
191
20.3 Key similarities and differences in management
control between for-profit and not-for-profit
organisations
Depending on their size, not-for-profit organisations use many of the same
controls as for-profit organisations. All the issues mentioned in Chapter
11 of the subject guide are relevant. Both types of organisation face the
same need for an organisational structure that ensures that employees are
controlled and rewarded, and that good financial systems and checks are
in place.
The key difference is that for-profit companies are required to make a
profit to survive, and preferably maximise profits to meet shareholders’
expectations. They will also have other goals to meet the needs of other
stakeholders.
Not-for-profit organisations do not have this profit goal, but they must
stay financially solvent so that they have the funds to fulfil their purposes.
Therefore they need to define their goals clearly before they can focus on
how to meet them. A local authority must serve its citizens and so must
identify the actions required to meet each of their needs and the different
resources required to do so. This means that their intended outcomes must
be clearly understood.
However, as any observer of national, local or club level politics knows,
deciding on the priorities for spending funds and raising funds is not
always easy. Priorities can be influenced by strong personalities, pressure
groups, the media and public opinion.
20.3.1 Goal ambiguity and conflict
Goal ambiguity arises because there are many competing needs for funds
and usually difficulties and/or resistance to raising the funds required. For
example, should a charity’s funds be used for a sudden emergency if this
means diverting funds from an ongoing project?
Organisations will identify the main activities that have to be undertaken
to meet their stated objectives.
Annual budget preparation tends to be a political process as it determines
the amount of money that will be available every year for each type of
service.
For many organisations, particularly national and local governments, much
of the basic work has been done for many years. Therefore their main
objective is to continually adjust the services to meet modern changing
needs with modern methods.
Conflicts arise continuously as circumstances change. For example, should
a hospital prioritise paediatrics or cancer care, since both could do so
much with more money?
20.4 Not-for-profit budgeting
For not-for-profit organisations, the budget is a vital mechanism for
authorisation and control, even more so than for for-profit organisations.
The funds available are finite and are devolved to managers to meet the
needs of their department. One of their performance measures will be to
keep within the budget while delivering services at the required level.
AC3193 Accounting theory
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Three criteria which can be used together are:
• Economy – this measure tests whether the resources are as cheap as
possible, given the quality required.
• Efficiency – this measures the output achieved from the inputs used.
• Effectiveness – this determines whether the expected objectives were
achieved.
Many organisations use incremental budgeting as their starting point each
year. This uses last year’s budgeted amount for each department and adjusts
it for known changes for the forthcoming year. This is the quickest and
easiest way of dealing with the huge task of budget preparation. However, it
is known to encourage budgetary slack. It may also fail to take into account
one-off amounts granted for a particular purpose in a previous year. This
amount may be included in subsequent budgets even though it is no longer
needed for that purpose. It also encourages departments to spend up to the
budget to ensure that the next budget will not be cut.
Situations may arise where funds for the whole organisation have been
cut from previous levels for the following period due to recession and
poor collection of taxes, or, alternatively, more money becomes available
than previously. How should those in authority cope with either cutting
expenditure or agreeing to more spending? What services should be affected?
One of the ways that this can be handled is to cut or increase each
department’s budget by the same proportion as the general change. A
reduction leads to departments individually deciding where to make cuts
and sometimes leads to whole activities, in several departments, having to
be cut. If there is an increase and it is spread across all departments, there
is often not enough to fund a new initiative in any one department so the
money is frittered away on non-essentials.
In order to minimise budgetary game playing and create more effective
decision-making, zero-based budgeting was introduced in 1970. Managers
are asked to identify each activity that their department performs and
justify every cost related to it, starting from scratch. This encourages
budgets which have grown over time to be rationalised. Also, each manager
is asked to prepare estimates of how extra money (say £100,000) could be
spent most effectively in their department so as to achieve more activities or
what they would cut if the money was withdrawn from their budget. These
are known as decision packages. This information allows management
to rank the importance of each decision package against strategic goals
and allocate resources appropriately. The practice may be harder on some
departments than on others, but is intended to be more effective overall.
The process of zero-based budgeting is very time-consuming so generally it
is not be done every year. However, the decision package approach could be
used whenever it is appropriate.
For example, a school might ask different disciplines (science, music, art,
sport, languages) what they could do with extra money (or what they
would cut if money was withdrawn from their budget).
The method attempts to:
• identify and discontinue obsolete activities
• increase staff involvement and understanding of how costs arise
• allocate or reduce resources more effectively.
This tool is not without the risk that managers will exaggerate the benefits
or losses that their department would experience. It can also lead to
tension or resentment.
Chapter 20: Management control in not-for-profit organisations
193
Once the annual budgets and planned outcomes have been decided,
targets are set to monitor the outcomes as the year progresses. The targets
may be partly informed by the previous year’s achievements, in the same
way that happens in for-profit companies.
20.5 Difficulties in measuring and rewarding
performance
In order to be able to control not-for-profit organisations, departments
have specific responsibilities that must be met, within a budget. As with
any budget mechanism, this meets with problems of uncertainty over how
much money is required and the likelihood of budgetary slack. However,
many activities can be measured in the same way as they are in for-profit
companies. For example, the time it should take to collect refuse in each
district can be specified; procedures for routine hospital activities can be
laid down, and in both cases action controls can be used.
In not-for-profit organisations, more difficult outcomes tend to have to
be measured. For example, how do you assess whether social work cases
are being handled correctly or if schoolchildren are achieving at expected
levels?
In arenas where several institutions are performing the same work (e.g.
school, hospitals, police forces, prisons), benchmarking is a useful way of
analysing performance. This can be developed into league tables. However,
emphasising the unit’s position in a league table should be used with care
as it can lead to incongruent behaviour by the unit in order to meet the
statistics. Targets may be met by taking resources from other important
activities that are not measured. The measures can be compromised, in
much the same way as is observed in for-profit companies. To use the
measures most effectively, organisations that are not achieving as well
as others should be encouraged to learn from the practices of the most
effective performers. It is also important to incorporate intervening
variables within the measures. For example, schools situated in areas
where pupils are not easily able to continue their studies at home are
likely to be less successful in terms of academic achievement and therefore
they may need more money to develop after-school homework clubs.
In some situations, possibly charities, few comparisons can be made, as the
activity is unique to that organisation. These organisations must develop
their own output measurement methods. One aspect which large charities
often publicise is the percentage of their donations that they spend on
administration. They obviously attempt to keep these costs as low as
possible.
An example of the difficulty that can arise in measuring and rewarding
actions was illustrated when people taking part in an archaeological dig
were paid extra for each item discovered. Unfortunately, this led to diggers
breaking larger items in two so they could receive double pay.
Activity 20.2
Discuss the effect that school league tables have on staff, pupils, parents and prospective
families.
AC3193 Accounting theory
194
20.6 Accounting differences
In the UK, accounting standards have been compiled for local authorities
based on international financial reporting standards (IFRS) and are issued
jointly by the Chartered Institute of Public Finance and Accountancy
(CIPFA) and LASAAC (the Local Authority Code Board). Charity
regulations in the UK are laid down by the Charities Commission.
The main difference, compared with limited company accounts, is the use
of fund accounting for donations and grants, some of which have been
given for a specific purpose. The use of each fund is recorded and reported
separately. The funds fall into different categories – restricted funds,
designated funds and general funds, which may have different titles in
different jurisdictions.
Restricted funds can only be used for the specific purpose for which they
were set up. For example, a church requires £180,000 to repair its historic
organ. A fundraising campaign is launched and the money is credited
to the restricted organ fund account. This may not be a separate bank
account, but the funds cannot be used for any other purpose. Sometimes
there are opportunities to obtain grants from the government or other
institutions which will match the funding raised by public donations.
Donors will wish to be sure that the money they have given is kept
separately so that the matching funding will be claimed and that money is
only used for the specific purpose.
Designated funds are created for a specific purpose. An example is a
maintenance fund, deliberately set up and financed by fundraising and by
moving funds from the general fund in order to have resources available
for the repair and replacement of assets. These funds are not restricted
and, with the agreement of trustees, can be moved to a different fund if it
is clear that they are not needed for their original purpose.
Auditors will ensure that the funds are only used for the designated
purpose.
The general fund is used to record an organisation’s day-to-day activities.
The income and expenditure account (the general fund) is very similar
to an income statement of a for-profit company but shows any surplus
or deficit for the year rather than net income or net loss. Balance sheets
(where used) also have similarities to their commercial counterparts.
Charities will incorporate all their funds into a consolidated statement
called the statement of changes in fund balances, which shows grants,
money donated, money transferred between funds and monies paid out to
fulfil the restricted or designated needs of the fund.
Activity 20.3
Use the internet to access a charity’s annual report. Look at the roles of the trustees. How
are designated funds accounted for?
20.7 External scrutiny
Not-for-profit organisations are answerable to their stakeholders and
the general public. The existence of widely available information makes
it even more likely that they will be scrutinised. Often, government
regulators have the power to intervene when it is clear that the
organisation is struggling. Directors and trustees can be replaced.
Chapter 20: Management control in not-for-profit organisations
195
Activity 20.4
Read the examples in the section ‘External scrutiny’ in Merchant and Van der Stede
(2017) Chapter 16. Make notes on people putting pressure on organisations to be more
effective, then discuss these with other students on the VLE.
There is a risk, particularly in charities, that inappropriate people will
be appointed to high office, such as a large donor or someone who
is well-known in another sphere who brings a good reputation to the
organisation. Often trustees are not paid or are only paid a small amount
(the charity regulations may bar them from being paid) and may have
their own careers so they may not be giving enough skill or attention to
ensuring that the organisation is effectively run.
20.8 Public sector scorecard
In the UK, the Public Sector Scorecard Research Centre is working with
some public sector bodies to develop a scorecard designed for public sector
organisations to help them to focus on continuously developing their
service delivery.
Clarifying
outcomes
Identifying processes
and capability outputs
Strategy
mapping
Integrating risk
management
Re-designing
processes
Addressing
capablility
Developing
performance
measures
Learning from
performance
measuresM
ea
su
re
m
en
t
an
d
ev
al
ua
ti
on
Strategy m
apping
Service improvement
Figure 1: A scorecard for public sector organisations. Source: Moullin, M. ‘How the
public sector scorecard works’, Public sector scorecard www.publicsectorscorecard.co.uk/how-
the-pss-works.html
The scorecard starts with ‘strategy mapping’, that is, working with staff
and service users to identify expected outcomes and the capabilities and
the processes needed to meet them. This leads to investigating ‘service
improvement’ by redesigning processes, including supporting and training
staff to adopt more effective practices.
The next step – ‘measurement and evaluation’ – is defining and agreeing
on appropriate performance measures for each part of the strategic
map. These are filtered to ensure that they are cost effective, provide the
intended value and minimise any undesirable outcomes.
AC3193 Accounting theory
196
20.9 Employment characteristics
Public sector employees understand that, in some ways, pay structures
and tenure are different from those in the private sector. Salaries are
usually agreed by unions and may include annual cost of living pay rises or
increases when additional responsibilities are taken on. There is usually a
good possibility of tenure unless the organisation needs to downsize. (This
is also true of many roles in the private sector.)
Public sector organisations rarely offer an opportunity for a bonus
structure directly related to performance as is the case in for-profit
companies, but many organisations have pay scales which recognise
greater experience.
It is important to employ (and pay) good quality people if the not-for-
profit organisation is to be well-run, with staff using their initiative to
continuously improve the service provided. Often top salaries are similar
to those in for-profit companies and therefore there is an expectation that
the organisation will be well-run and provide a good service. This must
be reflected in all departments, including the financial operation where
efficient working and good internal controls are essential.
There are many jobs that are only available in public sector organisations
(e.g. social work). Many people who choose to work for charities are
partly drawn to these organisations by a desire to work for a good cause.
Activity 20.3
Read the examples in the section ‘Employee characteristics’ in Merchant and Van der
Stede (2017) Chapter 16, relating to the Los Angeles Department of Mental Health and
the attitude of the mayor towards paying high salaries. Do some research to find out how
top salaries in commercial companies in your city or region relate to those in the private
sector. For example, how much is the chief executive of a company based in your city or
region paid (this information will be available in companies’ annual reports) compared to
a top executive in your local authority?
20.10 Summary
Due to the complexity of the goals and the number of interested parties in
not-for-profit organisations, a command and control style of management
may not be effective (some argue that in an innovative and creative
business it is not appropriate either). There are many situations where
discussions are needed to obtain consensus on action, and layers of
regulation, overseers and interest groups need to be satisfied. Results
measures and reward by specific financial bonuses are difficult to identify
and implement. Bonuses may be prohibited by law and are subject to
public scrutiny. However, many people are more comfortable working in
this environment.
20.11 Reminder of learning outcomes
Having completed this chapter, and the Essential reading and activities,
you should be able to:
• identify different types of not-for-profit organisation and give
examples of the main types
• explain the main similarities and differences between for-profit and
not-for-profit organisations
Chapter 20: Management control in not-for-profit organisations
197
• discuss ways in which public sector outputs can be identified and
measured
• explain fund accounting
• identify the ways in which public sector employment may differ from
that in the private sector.
20.12 Test your knowledge and understanding
1. Explain each of the following techniques and why each may be used in
not-for-profit organisations:
• zero-based budgeting
• benchmarking
• public sector scorecard.
Notes
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Appendix 1: Solutions to activities and Sample examination questions
199
Appendix 1: Solutions to activities and
sample examination questions
Note to students
Solutions are provided only for selected activities and Sample examination
questions.
Chapter 3
Activity 3.2
V2010 = £22,942 (straight forward sum of discounted cash flows)
Activity 3.3
Net present value of the project = £4,560 (leave out the initial outlay)
Sample examination question
Variables ex ante:
• D1t0 =8,000.
• V1t0 = 8,000/0.1 = 80,000.
• V0t0 = 8,000/0.1 = 80,000.
Variables ex post:
• D1t1 = 8,000.
• V1t1 = 16,000/0.2 = 80,000.
• V0t1 = 8,000/1.1 + 80,000/1.1 = 80,000.
i. Income number 1 ex ante = £8,000.
ii. Income number 2 ex ante = £8,000.
iii. Income number 1 ex post = £8,000.
iv. Income number 2 ex post version a:
= D1t1 + V1t1 − number 2 ex ante/r1t1 = 8,000 + 80,000 − 8,000/0.2 = 48,000.
Reconciliation:
Ex ante income = 8,000
Change in forecasted flows 8,000/0.1 = 80,000
Change in interest rate 8,000/0.2 − 8,000/0.1 = (40,000)
Income number 2 ex post version a = 48,000
iv. Income number 2 ex post version b:
V0t1 = [Y/(1+r0t1) + Y/(r1t1)] × 1/(1+r0t0) =
80,000 = [Y/1.1 + Y/0.2] × (1/1.1)
Y = 14,667.
Reconciliation:
Ex ante income = 8,000
Change in forecasted flows 8,000/0.2 × 1/1.2 = 33,333
Interest on revision to capital @ 20% 33,333 × 0.2 = 6,667
Income number 2 ex post version b = 14,667
AC3193 Accounting theory
200
Chapter 4
Sample examination question
Worked solution: B
Income statement for the year ended 31 December 2014
£ £ Index
Sales revenue 4,050,000 4,050,000
Less: Cost of sales
Opening inventories 225,000 1.08 243,000
Purchases 2,700,000 2,700,000
Closing inventories (270,000) 0.96 (260,357)
2,655,000 2,682,643
Gross profit 1,395,000 1,367,357
Expenses 450,000 450,000
Depreciation 126,000 1.50 189,000
Net profit 728,357
Non-current asset: Unrealised 1,944,000
Inventory: Unrealised 9,643
Non-current asset: Realised 63,000
Inventory: Realised 27,643
Retained profit 819,000 2,772,643
Statement of financial position as at 31 December 2014
£ Index
Non-current assets
Property, plant & equipment (PPE) 3,888,000 1.50 5,832,000
Inventories 270,000 1.04 279,643
Other net current assets 1,161,000 1,161,000
Net Assets 5,319,000 7,272,643
Share capital (£1 shares) 4,500,000 4,500,000
Retained profits 819,000 2,772,643
Equity 5,319,000 7,272,643
Appendix 1: Solutions to activities and Sample examination questions
201
Worked solutions: C
FSCVA CPP
Non-current asset: real unrealised 5,832,000 4,665,600 1,166,400
CVA*CPP HCA*CPP
Inventory: real unrealised 279,643 281,739 (2,096)
CVA*CPP HCA*CPP
Non-current asset: real realised 189,000 151,200 37,800
CVA*CPP HCA*CPP
Note: in the above three calculations, CPP=1 for FSCVA as the CVA are all stated at year end values
Inventory: real realised – Method A 2,926,519 2,896,364 30,156
Note: This method assumes we have only a single cost of sales total and not individual
constituents (i.e., opening & closing inventory; purchases) making up cost of sales
Inventory: real realised – Method B 2,926,519 2,933,715 (7,196)
Note: We calculate CPP for each constituent figure in the cost of sales, and the sum of these
gives the CPP cost of sales; we choose this method if we have all the detailed information provided
Inventory: real realised – Method C 2,926,519 2,920,909 5,610
Strictly speaking, if the average (30 June RPI) is affected by the removal of closing inventory
we have to use 30 June RPI for closing inventory instead of 30 Nov RPI
Holding gains (NCA and inventories, real realised and real unrealised) all in the statement of financial
performance
AC3193 Accounting theory
202
Chapter 5
Activity 5.1
The most appropriate course of action is to buy a new suit. You don’t
have time to get it cleaned and you would not want to miss your
interview because it has the potential to give you the opportunity to
earn £20,000 p.a. The deprival value would reflect this decision and
hence it would equal the replacement cost of the suit (i.e. £800). This
is lower than the higher of the NRV of your suit, which equals £0, and
the PV, which equals the future cash flows you could earn from the job
(i.e. greater than £20,000).
Activity 5.2: CheapAir Ltd
Deprival value of 106B
For aircraft 106B, the RC= £370,000, NRV = £340,000 and PV =
£289,400. Given the data, the company should sell the asset since the
NRV > PV. Given that the NRV is lower than the RC, the deprival value
would be equal to the NRV of £340,000.
Calculation of PV for 106B
Cash flow PV
Annual contribution in service 60,000
i. Present value 227,400
Terminal realisation value 100,000
ii. Present value of terminal realisation62,000
Total present value of future contribution in use 289,400
Appendix 1: Solutions to activities and Sample examination questions
203
Activity 5.3
AC3193 Accounting theory
204
Activity 5.4
Appendix 1: Solutions to activities and Sample examination questions
205
Activity 5.5a
AC3193 Accounting theory
206
Activity 5.5b
Appendix 1: Solutions to activities and Sample examination questions
207
Sample examination questions
Suggested Solution:
Basic:
Net annual saving = Rent saved − annual maintenance on present
machine = £8,500 − £5,000 =£3,500.
Present value of perpetuity at 10% = £3,500/0.1 = £35,000 = present
value.
Replacement cost (RC)= £45,000.
Net realisable value (NRV) = £30,000.
Present value (PV) in use = £35,000. PV > NRV and PV < RC. Worthwhile for company to retain the asset since it is worth more in use that selling asset and PV is greater than RC. Therefore, deprival value = PV in use = £35,000. Super: Annual contribution in service =£120,000. PV of 10 year annuity at 10% = £120,000 × 6.145 = £737,400. Terminal realisation value = £300,000. Present value of terminal realisation value = 0.386 × 300,000 = £115,800. Present value = 737,400 + 115,800 = £853,200. RC = 750,000. NRV = 720,000. PV in use = 853,200. PV > NRV and RC < PV. Present value is greater than NRV therefore retain asset. As PV is greater than RC firm must replace asset to maintain PV so that maximum loss the firm would suffer by being deprived of the asset is the RC. Deprival value = RC = £750,000. AC3193 Accounting theory 208 Notes Chapter 1: Introduction 1.1 Introduction 1.2 Syllabus 1.3 Aims of the course 1.4 Learning outcomes for the course 1.5 Introduction to the subject area 1.6 Route map to the guide 1.7 Overview of learning resources 1.8 The examination Chapter 2: Introducing accounting theory 2.1 Introduction 2.2 Introducing accounting theory 2.3 Positive/descriptive vs normative/prescriptive theorising of accounting 2.4 Notions of inductive and deductive theorising in accounting and other categorisations of theorising 2.5 Overview of chapter 2.6 Reminder of learning outcomes 2.7 Test your knowledge and understanding 2.8 Sample examination questions Chapter 3: Economist’s interpretation of income measurement and capital measurement 3.1 Introduction 3.2 A view of income and capital often characterised as the accountant’s view 3.3 A view of income and capital often characterised as the economist’s view 3.4 Hicks’s version of the economist’s concept of income 3.5 Hicks’s income number 1 3.6 Income ex ante and income ex post 3.7 What if interest rates are expected to change? 3.8 Hicks’s income number 2 3.9 Hicks’s income number 3 3.10 Implications of Hicks’s measures of income 3.11 Implications for accountants 3.12 Reminder of learning outcomes 3.13 Sample examination questions Chapter 4: Accounting for changing prices/values 4.1 Introduction 4.2 Introduction to current value accounting (CVA) 4.3 Worked example and explanation of CVA 4.4 Combined CPP/CVA system 4.5 Reminder of learning outcomes 4.6 Sample examination question Chapter 5: Deprival value 5.1 Introduction 5.2 Deprival value 5.3 Conceptualising replacement costs in DV 5.4 Advantages and disadvantages of deprival value 5.5 Reminder of learning outcomes 5.6 Sample examination question Chapter 6: Positive/descriptive economistic theory of accounting 6.1 Introduction 6.2 Historical context 6.3 The character of positive/descriptive economistic accounting theory 6.4 Theories linking accounting with the notion of efficient markets 6.5 Other studies 6.6 Critique 6.7 Overview of chapter 6.8 Reminder of learning outcomes 6.9 Test your knowledge and understanding 6.10 Sample examination questions Chapter 7: Theorising accounting through an interpretive approach 7.1 Introduction 7.2 The basic character of interpretive accounting theory 7.3 Relatively early interpretive accounting theory contributions 7.4 More recent variants of interpretive accounting theory 7.5 Critique 7.6 Overview of chapter 7.7 Reminder of learning outcomes 7.8 Test your knowledge and understanding 7.9 Sample examination questions Chapter 8: Critical accounting theory 8.1 Introduction 8.2 Delineation of critical accounting theory 8.3 Some themes of critical accounting theorising: too negative? 8.4 Critique 8.5 Overview of chapter 8.6 Reminder of learning outcomes 8.7 Test your knowledge and understanding 8.8 Sample examination questions Chapter 9: Theorising of accounting regulation I: normative/prescriptive theorising 9.1 Introduction 9.2 Accounting regulation: context 9.3 Prescriptive theory and accounting standards 9.4 Some regulatory implications 9.5 Overview of chapter 9.6 Reminder of learning outcomes 9.7 Test your knowledge and understanding 9.8 Sample examination questions Chapter 10: Theorising of accounting regulation II: positive/descriptive theorising 10.1 Introduction 10.2 Positive/descriptive theorising of accounting regulation that has emphasised the economistic 10.3 Accounting regulation from a political economy perspective 10.4 Cultural and institutional ways of seeing accounting regulation 10.5 Ideologies and rhetoric of accounting regulation 10.6 Studying the interface between the global and national 10.7 Overview of chapter 10.8 Reminder of learning outcomes 10.9 Test your knowledge and understanding 10.10 Sample examination questions Part 2: Management accounting Introduction Organising your studies Chapter 11: Introduction to control systems – personnel controls, cultural controls, action controls and results controls 11.1 Introduction 11.2 The importance of management control 11.3 Causes of management control problems 11.4 Action, personnel and cultural controls 11.5 Results controls 11.6 Conditions needed to implement effective results controls 11.7 Reminder of learning outcomes 11.8 Case studies 11.9 Test your knowledge and understanding Chapter 12: Control system tightness and control system costs 12.1 Introduction 12.2 Control system tightness 12.3 Control system costs 12.4 Adaptation of control systems 12.5 Summary 12.6 Reminder of learning outcomes 12.7 Case study 12.8 Test your knowledge and understanding Chapter 13: Designing and evaluating management control systems. Identifying financial responsibility centres 13.1 Introduction 13.2 Designing and evaluating management control systems (MCS) 13.3 Identifying financial responsibility centres and transfer pricing methods 13.4 Transfer pricing 13.5 Methods of setting transfer prices 13.6 Reminder of learning outcomes 13.7 Case study 13.8 Test your knowledge and understanding Chapter 14: A detailed look at planning and budgeting 14.1 Introduction 14.2 Budget purposes 14.3 Planning cycles 14.4. Target setting 14.5 Recasting the budget 14.6 Common financial performance target issues 14.6 Criticisms of budgeting and consideration of beyond budgeting 14.7 Reminder of learning outcomes 14.8 Case study 14.9 Test your knowledge and understanding Chapter 15: Incentive systems 15.1 Introduction 15.2 Purposes and types of incentives 15.3 Monetary incentives 15.4 Incentive scheme design 15.5 Incentive formulas and subjective rewards 15.6 The shape of the incentive function 15.7 Criteria for evaluating incentive systems 15.8 Group rewards 15.9 Reminder of learning outcomes 15.10 Case study 15.11 Test your knowledge and understanding Chapter 16: Financial performance measures and their effects 16.1 Introduction 16.2 Using market measures of performance for managerial appraisal 16.3 Using accounting measures of performance for managerial appraisal 16.4 Reminder of learning outcomes 16.5 Case study 16.6 Test your knowledge and understanding Chapter 17: Remedies to the myopia problem 17.1 Introduction 17.2 Pressures to act myopically 17.3 Ways to decrease myopia 17.4 Strengths of several performance measures 17.5 Issues in creating the correct measures 17.6 Reminder of learning outcomes 17.7 Case study 17.8 Test your knowledge and understanding Chapter 18: Using financial results controls in the presence of uncontrollable factors 18.1 Introduction 18.2 The controllability principle 18.3 Deciding on whether factors are uncontrollable 18.4 Controlling for the distorting effects of uncontrollables 18.5 Methods which can be used to determine the impact of the event 18.6 Reminder of learning outcomes 18.7 Case study 18.8 Test your knowledge and understanding Chapter 19: Management control-related ethical issues 19.1 Introduction 19.2 Ethical behaviour in a business context 19.3 Ethical models 19.4 Analysing ethical issues 19.5 Some management control-related ethical issues 19.6 Reminder of learning outcomes 19.7 Case study 19.8 Test your knowledge and understanding Chapter 20: Management control in not-for-profit organisations 20.1 Introduction 20.2 Types of not-for-profit organisation 20.3 Key similarities and differences in management control between for-profit and not-for-profit organisations 20.4 Not-for-profit budgeting 20.5 Difficulties in measuring and rewarding performance 20.6 Accounting differences 20.7 External scrutiny 20.8 Public sector scorecard 20.9 Employment characteristics 20.10 Summary 20.11 Reminder of learning outcomes 20.12 Test your knowledge and understanding Appendix 1: Solutions to activities and sample examination questions Note to students Chapter 3 Chapter 4 Chapter 5 _GoBack _GoBack _GoBack _GoBack _GoBack _GoBack _GoBack _GoBack _GoBack _GoBack _GoBack _GoBack

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