FINANCIAL ACCOUNTING

BUACC2606 Financial Accounting

Semester 1, 2012

Assessment weight:                            25%

Due Date:                                            Week 10

Length:                                                1500 words maximum

Group Assignment:                             2 people

Format:                                                Report – refer to marking guide attached

Collison (1998:7) states that “Attention to the interests of shareholders above all other groups is implicit in much of what is taught to accounting and finance students. The very construction of a profit and loss account is a continual, and usually un-stated, reminder that the interests of only one group of stakeholders should be maximised. Indeed it may be very difficult for accounting and finance students to even conceive of another way in which affairs could be ordered, even at the algebraic level, let alone the moral”

1. 1.               Do you agree or disagree with Collison, and why ?

Answer:  Yes. We agree with Collison. It is difficult for accounting and finance students to conceive of another way than maximizing shareholders wealth. There are two major approaches determining financial goals. One is shareholders wealth maximization and other is profit maximization. It is very necessary to decide financial goal of the business because every decision of the finance manager such as investment decision, financing decision and dividend policy decision depends on financial objectives.

 Shareholders’ wealth maximization decision criteria:

Shareholders’ wealth maximization criterion is also known Net Present Value maximization decision criteria. Academic literature and the limitations of other measures proved this criterion to be widely accepted financial goal of the firm. There are three main merits of this criterion over other criteria of setting financial goals.

1. Time Value of Money: Shareholders’ wealth maximization takes care of time value and risk of the benefits. In wealth maximization wealth or NPV is calculated by selecting a appropriate discount rate . In this way time value of the cash flows is known. BY selecting on positive NPV projects it maximizes wealth. It is cash flows of the project not the accounting profit that are taken in consideration while making decisions.

1. Unambiguous criterion: It is appropriate and feasible to choose best among many alternatives of financial actions if the shareholders wealth maximization or NPV criterion is followed. There is no ambiguity while making decisions based on Net Present Value.¹

1. Exactness: In shareholders’ wealth maximization criterion returns can be measured in exact or precise term. In this criterion Net Present Value is based on cash flows in which positive cash flows are accepted. Thus the returns can be measured in exact term.

1. Reflective Measure:  Shareholders’ wealth creation or positive cash flows get reflected in higher market price of the company shares. Thus there is a unbiased measure of reflecting the shareholders’ wealth in terms of share price movements.Though market value of share is not a proper measure of performance it has certain limitations as stated by Porterfield (1965).

Due to above stated merits of maximizing one group of stakeholders that is shareholders’ wealth or interest maximization is considered the appropriate objective in financial management.

^{1 Solomon, Ezra and Pringle John J. An Introduction to Financial Management, Prentice-Hall of India, 1978, pp.6-7}

1. 2.               If ‘profit’ maximisation is biased towards maximising the interest of only one stakeholder group, would you expect that over time there will be less emphasis on profits and more emphasis on other performance indicators?

Answer:   Yes. We agree that profit maximization is biased towards maximizing the interest of only one stakeholder group, we would expect that over time there will be less emphasis on profits and more emphasis on other performance indicators. Profit maximization ignores all other stakeholders such as employees, society, customers, etc. Profit maximization has many criticisms.²

Demerits of Profit Maximization Criterion

It is nothing but maximizing the accounting profit. Objective of profit maximization aims at increasing profitability, stability and efficiencies. But it has the following demerits over shareholders’ wealth maximization objective.

1. Ambiguous: Profit maximization objective is an ambiguous measure because the term profit is not clear, it varies person to person. Everyone defines the accounting profit in their own way.
2. Time value of the benefits: It does not consider the time value of the benefits. When the inflation is high value of profit goes down with time, therefore profit is not comparable over a long period.
3. Quality of benefits: It ignores quality benefits of the business like efficiency, employee skills and employees’ turnover, quality of management, share price , etc.
4. Harmful to the society: Profit can be maximized by following unethical and socially harmful methods also. Thus the goal of profit maximization can be harmful to the society.

^{2. oep.oxfordjournals.org/content/15/2/130.full.pdf}

1. 3.               What might be some of the alternative measures of performance?

Answer:  There are some alternatives of performance which are proposed by several researchers. These alternatives are as follows : ³

Satisficing  

Maximizing the profit may be replaced by satisficing (March and Simon 1958, Boulding 1955). In satisficing criterion minimum achievement level is decided whicn can satisfy to all the stakeholders. The results of achievement is seen in share prices of the company. When the firm’s share price moves downward the threat of hostile takeover would make the firm to put efforts on increasing the share prices. Similarly if the profit is large then firm has to reduce the prices due to investigation of Competition Commission and to improve firm image with the customers. Firm has to pay minimum wages to the workers to avoid any industrial action.

Sales Revenue Maximisation

Baumaol(1959) introduced the new objective of sales revenue maximization. He said day to day activities are manager-controlled ,all day to day decisions are taken by managers. Therefore their salary should be linked to total sales rather than accounting profit.

An alternative view point to the sales revenue maximization was given by Williamson (1963), who said managerial satisfaction or utility can be enhanced by raising sales revenue.

The total revenue is maximum when marginal revenue is zero,hence there should be a constraint on price decisions taken by the managers.

Management Discretion

Oliver E. Williamson (1964) stated that profit maximization is not the only objectives of the managers. He said utility maximization is the managers’ objective. The managers can use their own discretion in day to day decision making and maximize their own utility rather than maximizing shareholders’ wealth. This leads to principle –agent problem. This can also cause a threat to job security if a minimum profit is not maintained. Moreover this model is based on some unrealistic assumptions such as there is no perfect competition in the market, ownership and management are separate and a constraint of minimum profit to pay the dividends.

Consensus Model

Cyert & March (1963) argued that there are multiple stakeholders in an organization and each of them has their own objective. They try to maximize own interest in the organization, therefore there is always a coalition of different interest. Hence the management of the organization should try to reach a consensus with these different stakeholders and settle acceptable minimum limit of benefit to these groups which is less than what they want otherwise. In simple words this model asks every stakeholder to sacrifice some desired profit to maximize the total benefits.

Wealth Maximization Model

This model emphasizes on maximizing the Net Present Value rather the accounting profit. It maximizes the market value of the firm in terms of higher share prices. It focuses on accepting the investments by the firm in the projects with positive cash flows.

^{3.ideas.repec.org/a/aea/aecrev/v65y1975i4p689-94.html}

1. 4.               Would Collison’s comments provide a justification for moves towards profit measures that incorporate ‘full costs’ (considers the externalities of business)?

Provide some current examples of companies that support your point of view.

Answer:

Externality is an impact on parties which are not involved in given economic transaction. These are the costs or benefits not included in the goods’ or services’ market price but that affects the third parties which are not involved in the transactions. ⁴

For example education benefits the others also in the society not only to the student only. It is an example of positive externality. Air pollution, noise pollution are examples of negative externalities. Thus negative externalities or full costs of production are not considered in profit maximization and other alternatives of profit maximization such as sales revenue maximization, utility maximization etc.

• Examples of harvesting by fishing company results in reduced future stock.
• Using roads also causes congestion costs.
• High consumption by few consumers results in rise in the price causing reduction in the consumption of other consumers.

Current example of using green technology by the companies considers full costs performance measure by taking into account externalities.

Similarly corporate social responsibility is an example of giving back to the society for all the negative externalities caused due to business activities.

Rogerson (1997) and Reichelstein (1997) incorporates externalities in the goals of the firm. In their performance measure is not based on sole Net Present Value or Profit maximization measures rather they considered externalities also while making day to day decisions and setting the firm’s objectives.⁵

^{4http://www.history-society.com/externality.html}

^{5The externality annuity cost allocation rule only leads to perfect goal congruence if the considered in-vestment projects have the same lifespan. See Mohnen (2002), p. 193 for a discussion only one division if projects have different life spans.}

Pigou (1920) stated the solution for negative externality of smoke emission by a factory. This emission causes health deterioration of people living around. He said the Government should impose a per unit tax on output of these kind of firms. The tax per unit should be equal to the difference between social marginal cost and private marginal cost of the output produced by generating smokes. This kind of tax will raise the output price and reduce the demand of this output which can lead to changes in the decision making of the producers. Baumol argued that there is a serious problem of finding the difference between social marginal cost and private marginal cost.

REFERNCES

Collison, D.,1998, Propaganda, Accounting and Finance: An Exploration, Dundee Discussion Papers, Department of Accountancy and Business Finance, University of Dundee.

Boulding, K.E. (1955) Contributions of economics to the theory of conflict. Bulletin of the Research Exchange on the Prevention of War 3:51-59.

Cyert, Richard; March, James (1963). Behavioral Theory of the Firm. Oxford: Blackwell. ISBN 9780631174516.

March, J.G., and H.A. Simon (1958) Organizations. New York: Wiley.

Pigou, A.C. (1920), The Economics of Welfare, Macmillan.

Porterfield,James C.T. (1965). investment Decision and Capital Costs,Prentice-Hall.

Reichelstein, S. (1997): Investment Decisions and Managerial Performance Evaluation, in: Review of Accounting Studies, 2 (2), p. 157-180.

Rogerson, W.P. (1997): Intertemporal Cost Allocation and Managerial Investment Incen-tives: A Theory Explainung the Use of Economic Value Added as a Performance Measure, in: Journal of Political Economy, 105 (4), p. 770-795.

But you can order it from our service and receive complete high-quality custom paper.  Our service offers Accounting essay sample that was written by professional writer. If you like one, you have an opportunity to buy a similar paper. Any of the academic papers will be written from scratch, according to all customers’ specifications, expectations and highest standards.”