Chapter 4 - Solution Manual

That absent conservatism managerial compensation

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that, absent conservatism, managerial compensation agreements may reward managers based on current performance that may later prove unwarranted. According to Watts and Zimmerman, positive accounting theory should help us to better understand the sources of pressures that drive the accounting standard-setting process and how accounting standards affect individuals and individual behavior and thus the allocation of resources. According to the theory, managers of firms make accounting choices because of their own self interests. If we can better understand how accounting standards affect management, then we can do a better job of writing standards to help bring about appropriate, rather than dysfunctional management behavior. If we don’t know how accounting standards will be used, then it is unlikely that the goals of transparency and better reporting will be achieved. Positive, not normative accounting theory, explains observed accounting practice. Unlike normative accounting theory it does not rely on consensus of accounting professionals. Because there is no set of goals that is universally accepted by accountants, normative accounting theory development may not provide appropriate, practical accounting standards. Thus, since normative accounting theories rely upon acceptability, the resulting theoretical development may be suspect. Team 2 1Support reliance on normative theory to develop a general theory of accounting Normative accounting theory is based on sets of goals which prescribe the way financial reporting should be, not just how it is. If we do not know what we should be reporting, how can we expect to develop accounting standards whose use will produce financial reports that can be relied upon to present the true financial picture of the reporting entity? Accountants typically agree with the Conceptual Framework’s goal of providing decision-relevant financial information to users. Decision-relevant financial reports provide the user with information which they can use to predict future performance and to compare companies. Only accounting standards that are based on what ought to be are likely provide management with a consistent choice and application of accounting policies so that reported results are unbiased and transparent. Accounting standards derived from normative theory can result in financial statements that are consistent across time and among companies. Knowledge of how managers can use accounting information to bias financial results is useful, but does not provide accountants with what they need to prepare decision-relevant financials. Accounting standards should be based on clearly stated objectives that can be used to derive logical and consistent principles and practices. Just because there is no universally accepted set of objectives, does not mean that there should not be. There is, at least, a relatively wide acceptance of the underlying objectives and assumptions outlined in the FASB’s Conceptual Framework. These assumptions can certainly be relied upon to aid in the development of logical and consistent accounting standards.
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