Corporate Management and Accounting Standards

In this article we will discuss about the role of corporate management in determination of accounting standards.

Corporate managements play a central role in the determination of accounting standards. Corporate management is central to any discussion of financial reporting, whether at the statutory, or regulatory level or at the level of official pronouncements of accounting bodies.

Corporate managements influence the standard setting based on its own self-interest. As long as financial accounting standards have potential effects on the firm’s future cash flows, standard setting by (accounting) bodies will be met by corporate lobbying.

Watts and Zimmerman observe:

“Managers have greater incentive to choose accounting standards which report lower earnings (thereby increasing cash flows, firm value, and their welfare) due to tax, political and regulatory considerations than to choose accounting standards which report higher earnings and, thereby, increase their incentive compensation. However, this prediction is conditional upon the firm being regulated or subject to political pressure. In small (i.e., low political costs) unregulated firms, we would expect that managers do have incentives to select accounting standards which report higher earnings, if the expected gain in incentive compensation is greater than the foregone expected tax consequences. Finally, we expect management also to consider the accounting standard’s impact on the firm’s bookkeeping costs (and hence their own welfare).”

Watts and Zimmerman’s view of accounting standards need not to be applied for deciding good or bad accounting. The self-interest of management is all that counts, at least in determining the position of the preparers of financial statements.

Self-interest apparently points in opposite directions for large and small companies, mainly because large companies are more susceptible to political interference and are therefore more sensitive about appearing to be too prosperous.

However, Solomans does not agree with this view of Watts and Zimmerman and state that “the views that business advocate, which of course are not unanimous even within a single industry, cannot universally be explained by reference to their self-interest. And even if they could, there is nothing like a one-to-one relationship between the lobbying positions taken by any particular groups of firms and the standards that are eventually promulgated.”

Some persons argue that management should be given freedom and not be constrained by definitive sets of accounting measurement rules. This view does not appear to be correct and is not based on reality. Management should not be allowed to adopt any form of accounting it likes, for this type of freedom could lead to significant doubts the quality of financial reporting and thereby reduce its credibility and potential usefulness.

Given the freedom to managements, they may indulge in undesirable “creative accounting,” and tend to conceal the truth rather than to disclose. This does not mean that there is conflict between management and investors over the question of objectives and benefits associated with accounting standards.

Anything that makes the goals of investors and the goals of management congruent with each other will diminish the danger that accounting (and other) issues will be decided to the detriment of one group and in favour of the other.

The accounting profession’s efforts should be directed towards achieving consensus among the constituents, e.g., investors and creditors, managers, auditors, government, the public at large, who may have different interests, different needs, and different point of view in standards setting.

Without a consensus among the parties to accounting standards, there can be no effective enforcement. After studying the preferences (like and dislikes) of every constituent, the accounting profession should develop a measure of the overall “usefulness” of each preferred standard for all constituents and society.

Ronen observes:

“The arguments voiced for increasing the uniformity of accounting standards and reducing the flexibility of management in choosing among different accounting treatments could well be explained from an economic standpoint as means for reducing audit (monitoring) cost and for reducing the ambiguity of the resulting signal and the possible effect of such ambiguity on investors reaction. The larger the ambiguity of the signal resulting from an excessive flexibility on the part of management of choosing among accounting means of generating the signal, the lesser the reliability of the inference that can be made by investors on the basis of the signals received.”