Chapter 2 Theories of financial accounting. Copyright 2003 McGraw-Hill New Zealand Pty Ltd PPTs t/a New Zealand Financial Accounting 2e by Deegan and

Chapter 2Chapter 2

Theories of financial Theories of financial accountingaccounting

Copyright Copyright 2003 McGraw-Hill New Zealand Pty Ltd 2003 McGraw-Hill New Zealand Pty Ltd PPTs t/a PPTs t/a New Zealand Financial Accounting 2eNew Zealand Financial Accounting 2e by Deegan and Samkin by Deegan and Samkin

Slides prepared by Grant SamkinSlides prepared by Grant Samkin

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ObjectivesObjectives Be able to describe various Be able to describe various

normative and positive theories of normative and positive theories of financial accounting.financial accounting.

Be aware of some of the limitations Be aware of some of the limitations of the various theories of of the various theories of accounting.accounting.

Appreciate that there is no single Appreciate that there is no single unified theory of accounting.unified theory of accounting.



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Objectives (cont.)Objectives (cont.) Understand that the output of the Understand that the output of the

accounting process is frequently accounting process is frequently used in various contractual used in various contractual arrangements between an arrangements between an organisation and its managers and organisation and its managers and debt holders.debt holders.



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Objectives (cont.)Objectives (cont.) Understand the various pressures Understand the various pressures

and motivations that could and motivations that could potentially have an effect on the potentially have an effect on the methods of accounting selected by methods of accounting selected by an organisation.an organisation.

Understand what is meant by Understand what is meant by ‘creative accounting’ and why it ‘creative accounting’ and why it might occur.might occur.



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Theory definitionTheory definition A coherent group of propositions used as A coherent group of propositions used as

principles of explanation for a class of principles of explanation for a class of phenomena.phenomena.

A coherent group of hypothetical, A coherent group of hypothetical, conceptual and pragmatic principles conceptual and pragmatic principles forming a general framework of forming a general framework of reference for a field of inquiry.reference for a field of inquiry.

Accounting theories explain and predict Accounting theories explain and predict accounting practice (positive theories) or accounting practice (positive theories) or prescribe practice (normative theories).prescribe practice (normative theories).



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Positive Accounting Positive Accounting

Theory (PAT)Theory (PAT) PAT seeks to explain and predict PAT seeks to explain and predict

accounting practice.accounting practice. A positive theory explains and predicts A positive theory explains and predicts

accounting practice.accounting practice. Does not seek to prescribe particular Does not seek to prescribe particular

actions.actions. Grounded in economic theory.Grounded in economic theory.



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Positive Accounting Positive Accounting

Theory (PAT) Theory (PAT) (cont.)(cont.) Focuses on the relationships between Focuses on the relationships between

various individuals involved in various individuals involved in providing resources to an organisation providing resources to an organisation (agency relationship):(agency relationship):– owners and managersowners and managers– managers and debt providers.managers and debt providers.



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Agency theoryAgency theory

Agency relationshipAgency relationship– delegation of decision making from the delegation of decision making from the

principal to the agent.principal to the agent. Agency problemAgency problem

– delegation of authority can lead to loss of delegation of authority can lead to loss of efficiency and increased costs.efficiency and increased costs.

Agency costsAgency costs– costs that arise as a result of the agency costs that arise as a result of the agency

relationship.relationship.



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Agency costsAgency costs

Monitoring costsMonitoring costs Bonding expendituresBonding expenditures Residual lossResidual loss



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Assumptions of PATAssumptions of PAT

All individual action is driven by self-All individual action is driven by self-interest.interest.

Individuals will act in an opportunistic Individuals will act in an opportunistic manner to increase their wealth.manner to increase their wealth.

Notions of loyalty and morality not Notions of loyalty and morality not incorporated within the theory (nor, incorporated within the theory (nor, typically, in other accounting theories).typically, in other accounting theories).

Organisations are a collection of self-Organisations are a collection of self-interested individuals who agree to interested individuals who agree to cooperate.cooperate.



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PAT predictionsPAT predictions

Organisations will seek to put in place Organisations will seek to put in place mechanisms to align the interests of mechanisms to align the interests of managers of the firm (agents) with the managers of the firm (agents) with the interests of the owners (principals).interests of the owners (principals).

Some of these mechanisms rely on Some of these mechanisms rely on output of the accounting system.output of the accounting system.

Where accounting alignment Where accounting alignment mechanisms are in place, financial mechanisms are in place, financial statements need to be provided.statements need to be provided.



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Efficiency perspectiveEfficiency perspective

Mechanisms are put in place up front, Mechanisms are put in place up front, with the objective of minimising future with the objective of minimising future agency costs.agency costs.

Referred to as Referred to as ex anteex ante perspective. perspective. Accounting methods adopted by firms Accounting methods adopted by firms

best reflect the underlying financial best reflect the underlying financial performance of the entity.performance of the entity.

Regulation is therefore argued to Regulation is therefore argued to impose unwarranted costs on reporting impose unwarranted costs on reporting entities.entities.



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Opportunistic Opportunistic perspectiveperspective Considers opportunistic actions that Considers opportunistic actions that

could be undertaken once various could be undertaken once various contractual arrangements have been contractual arrangements have been put in place.put in place.

Referred to as Referred to as ex postex post.. Assumes managers will Assumes managers will

opportunistically select accounting opportunistically select accounting methods to increase their own methods to increase their own personal wealth.personal wealth.



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Owner/manager Owner/manager contractingcontracting Managers assumed to act in own self-Managers assumed to act in own self-

interest at expense of ownersinterest at expense of owners– ‘‘rational economic person’ assumption.rational economic person’ assumption.

Managers have access to information Managers have access to information not available to principalsnot available to principals– information asymmetry.information asymmetry.



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Methods of reducing Methods of reducing agency costs of equityagency costs of equity Price protectionPrice protection Monitoring by ownersMonitoring by owners Bonding by managersBonding by managers Managers may be rewarded:Managers may be rewarded:

– on a fixed basison a fixed basis– on the basis of the results achievedon the basis of the results achieved– on a combination of the two.on a combination of the two.



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Bonus schemesBonus schemes

Remuneration based on the output of Remuneration based on the output of the accounting system.the accounting system.

Based on:Based on:– profits of the firmprofits of the firm– sales of the firmsales of the firm– return on assets.return on assets.

May also be rewarded based on May also be rewarded based on market price of sharesmarket price of shares



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Accounting-based Accounting-based bonus schemesbonus schemes Any changes in the accounting Any changes in the accounting

methods used by the organisation will methods used by the organisation will affect the bonuses paid (e.g. as a affect the bonuses paid (e.g. as a result of a new accounting standard).result of a new accounting standard).

Contracts may rely on ‘floating’ Contracts may rely on ‘floating’ generally accepted accounting generally accepted accounting principles.principles.



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Incentives to Incentives to manipulate accounting manipulate accounting numbersnumbers Rewarding managers on the basis of Rewarding managers on the basis of

accounting profits can induce them to accounting profits can induce them to manipulate the related accounting manipulate the related accounting numbers to improve their apparent numbers to improve their apparent performance and related rewards.performance and related rewards.

Accounting profits may not always Accounting profits may not always provide an unbiased measure of a provide an unbiased measure of a firm’s performance.firm’s performance.



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Market-based bonus Market-based bonus schemesschemes Market prices are assumed to be Market prices are assumed to be

influenced by expectations about the influenced by expectations about the net present value of expected future net present value of expected future cash flows.cash flows.

May award a cash bonus based on May award a cash bonus based on increases in share prices or providing increases in share prices or providing managers with shares or options to managers with shares or options to shares in the firm.shares in the firm.



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Market-based bonus Market-based bonus schemes (cont.)schemes (cont.) Problem: market prices also reflect Problem: market prices also reflect

market-wide factors, not just factors market-wide factors, not just factors controlled by the manager.controlled by the manager.

Only senior management is likely to be Only senior management is likely to be able to affect cash flows and hence able to affect cash flows and hence securities prices.securities prices.

Market-related incentives might only Market-related incentives might only be appropriate for senior be appropriate for senior management.management.



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Role of auditorRole of auditor

If managers’ remuneration is based on If managers’ remuneration is based on accounting numbers, auditor takes a accounting numbers, auditor takes a monitoring role.monitoring role.

Arbitrates on the reasonableness of Arbitrates on the reasonableness of the accounting methods adopted.the accounting methods adopted.

However, there will always be scope However, there will always be scope for opportunism.for opportunism.



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Other ways that align Other ways that align interests of managers interests of managers and ownersand owners

Threat of takeovers to under-Threat of takeovers to under-performing firms.performing firms.

Well-informed labour market.Well-informed labour market.



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Debt contractingDebt contracting

Agency costs of debt:Agency costs of debt:– excess dividendsexcess dividends– additional or excessive levels of debtadditional or excessive levels of debt– claim dilutionclaim dilution– asset substitutionasset substitution– investment in risky projects.investment in risky projects.

Assumption: managers’ interests are Assumption: managers’ interests are aligned with shareholders’ interests.aligned with shareholders’ interests.



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Ways to minimise Ways to minimise agency agency costs of debtcosts of debt Price protectionPrice protection

– higher interest charges.higher interest charges. ContractingContracting

– interest coverage clausesinterest coverage clauses– debt to asset clauses.debt to asset clauses.

leverage clauses frequently used in Australian leverage clauses frequently used in Australian bank loan contracts.bank loan contracts.

MonitoringMonitoring



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Political costsPolitical costs

Costs that groups external to the firm may Costs that groups external to the firm may be able to impose on the firm:be able to impose on the firm:– increased taxesincreased taxes– increased wage claimsincreased wage claims– product boycottsproduct boycotts– decreased subsidies.decreased subsidies.

Organisations are affected by Organisations are affected by governments, trade unions, environmental governments, trade unions, environmental lobby groups or particular consumer lobby groups or particular consumer groups.groups.



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Political costs (cont.)Political costs (cont.)

Demands placed on the firm may be Demands placed on the firm may be affected by accounting resultsaffected by accounting results– higher reported profitshigher reported profits– how accounting numbers are generated is how accounting numbers are generated is

not important.not important. Accounting numbers may be used as a Accounting numbers may be used as a

means of providing ‘excuses’ for means of providing ‘excuses’ for effecting wealth transfers in the effecting wealth transfers in the political process.political process.



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Ways to reduce political Ways to reduce political costscosts Management may:Management may:

– adopt income-reducing accounting adopt income-reducing accounting techniquestechniques

– make voluntary social disclosures.make voluntary social disclosures.



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PAT in summaryPAT in summary

Selection of accounting methods can Selection of accounting methods can be explained by either efficiency or be explained by either efficiency or opportunistic arguments.opportunistic arguments.

Accounting methods can impact cash Accounting methods can impact cash flows associated with debt and flows associated with debt and management compensation contracts.management compensation contracts.

These effects can be used to explain These effects can be used to explain why particular accounting methods are why particular accounting methods are used.used.

The use of particular accounting The use of particular accounting methods can have opposing effects.methods can have opposing effects.



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Accounting policy Accounting policy selection and selection and disclosuredisclosure To allow comparison between reporting To allow comparison between reporting

entities:entities:– a summary of accounting policies must be a summary of accounting policies must be

presented in the notes to the financial report presented in the notes to the financial report (FRS-1, 5.1).(FRS-1, 5.1).

– where accounting policy has changed and the where accounting policy has changed and the change has a material effect on results, the change has a material effect on results, the notes must disclose the nature of, reason for, notes must disclose the nature of, reason for, and financial effect of the change (FRS-1, and financial effect of the change (FRS-1, 5.11). 5.11).

requirement also consistent with Statement of requirement also consistent with Statement of ConceptsConcepts



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Accounting policy Accounting policy choice and ‘creative choice and ‘creative accounting’accounting’ ‘‘Creative accounting’ refers to the Creative accounting’ refers to the

selection of accounting methods that selection of accounting methods that provides the result desired by provides the result desired by preparers.preparers.

Also known as opportunistic.Also known as opportunistic. Can be creative and still follow Can be creative and still follow

accounting standards.accounting standards.



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Criticisms of PATCriticisms of PAT Does not provide prescription, so does Does not provide prescription, so does

not provide a means of improving not provide a means of improving accounting practice.accounting practice.

Not value free but is value laden.Not value free but is value laden. Underlying assumption of wealth Underlying assumption of wealth

maximisation.maximisation. Issues being addressed have not Issues being addressed have not

shown great development.shown great development. Scientifically flawed.Scientifically flawed.



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Normative Normative accounting theoriesaccounting theories Seek to provide guidance to select Seek to provide guidance to select

accounting procedures that are most accounting procedures that are most appropriate.appropriate.

Prescribe what should be done.Prescribe what should be done.



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Statement of conceptsStatement of concepts

Considered a normative theory.Considered a normative theory. Seeks to identify the objective of GPFR.Seeks to identify the objective of GPFR. Seeks to provide recognition and Seeks to provide recognition and

measurement rules within a ‘coherent’ measurement rules within a ‘coherent’ and ‘consistent’ framework.and ‘consistent’ framework.

Identifies the qualitative characteristics Identifies the qualitative characteristics financial information should possess.financial information should possess.



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Other normative Other normative theoriestheories Three main classifications:Three main classifications:

– current-cost accountingcurrent-cost accounting– exit-price accountingexit-price accounting– deprival-value accounting.deprival-value accounting.

Addressed issues associated with Addressed issues associated with changing prices.changing prices.

Developed in 1950s and 1960s during Developed in 1950s and 1960s during a period of high inflation.a period of high inflation.



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Current-cost accountingCurrent-cost accounting

Aim is to provide a calculation of Aim is to provide a calculation of income that, after adjusting for income that, after adjusting for changing prices, can be withdrawn changing prices, can be withdrawn from the entity and still leave the from the entity and still leave the physical capital (operating capacity) physical capital (operating capacity) of the entity intact.of the entity intact.– referred to as true measure of income.referred to as true measure of income.



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Current-cost accounting Current-cost accounting (cont.)(cont.) True income theories propose a True income theories propose a

single measurement basis for assets single measurement basis for assets and a consequent single measure of and a consequent single measure of income (profit).income (profit).



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Exit-price accountingExit-price accounting

Continuously Contemporary Continuously Contemporary Accounting.Accounting.

Uses exit or selling prices to value the Uses exit or selling prices to value the entity’s assets and liabilitiesentity’s assets and liabilities– referred to as current cash equivalents.referred to as current cash equivalents.



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Exit-price accounting Exit-price accounting (cont.)(cont.) Assumptions:Assumptions:

– firms exist to increase the wealth of the firms exist to increase the wealth of the ownersowners

– ability to adapt to changing circumstancesability to adapt to changing circumstances– capacity to adapt best reflected monetary capacity to adapt best reflected monetary

value of assets, liabilities and equities at value of assets, liabilities and equities at balance date, where monetary value of balance date, where monetary value of based on the current exit or selling prices.based on the current exit or selling prices.



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Deprival-value Deprival-value accountingaccounting Deprival value represents the amount Deprival value represents the amount

of loss that might be incurred by an of loss that might be incurred by an entity if it was deprived of the use of entity if it was deprived of the use of an asset and the associated economic an asset and the associated economic benefits.benefits.

Considers:Considers:– the net selling pricethe net selling price– the present value of future cash flowsthe present value of future cash flows– an asset’s current replacement cost.an asset’s current replacement cost.



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Systems-oriented Systems-oriented theoriestheories Focuses on the role of information and Focuses on the role of information and

disclosure in the relationships between disclosure in the relationships between organisations, the State, individuals organisations, the State, individuals and groups.and groups.

The entity is assumed to be influenced The entity is assumed to be influenced by the society in which it operates, and by the society in which it operates, and to have an influence on it.to have an influence on it.



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Systems-oriented Systems-oriented theories (cont.)theories (cont.) Systems-based theories include:Systems-based theories include:

– stakeholder theorystakeholder theory– legitimacy theory.legitimacy theory.



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Stakeholder theoryStakeholder theory

Two branchesTwo branches– ethical (normative) branchethical (normative) branch– managerial (positive) branch. managerial (positive) branch.



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Stakeholder theory Stakeholder theory (cont.)(cont.) Ethical branchEthical branch

– Stakeholders are any group or individual Stakeholders are any group or individual who can affect, or are affected by, the who can affect, or are affected by, the achievement of the firm’s objectives.achievement of the firm’s objectives.

– Includes shareholders, employees, Includes shareholders, employees, customers, lenders, suppliers, local customers, lenders, suppliers, local charities, interest groups, government etc.charities, interest groups, government etc.

– All stakeholders have a right to be All stakeholders have a right to be provided with information.provided with information.



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Stakeholder theory Stakeholder theory (cont.)(cont.) Managerial branchManagerial branch

– Seeks to explain and predict how an Seeks to explain and predict how an organisation will react to demands of organisation will react to demands of various stakeholders.various stakeholders.

– The organisation identifies its group of The organisation identifies its group of stakeholders:stakeholders:

relative power or importance of stakeholders relative power or importance of stakeholders consideredconsidered

relative power and importance can change across relative power and importance can change across time—associated with control of resourcestime—associated with control of resources

the firm will take actions to ‘manage’ the the firm will take actions to ‘manage’ the relationships with stakeholders.relationships with stakeholders.



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Stakeholder theory Stakeholder theory (cont.)(cont.) Managerial branch (cont.)Managerial branch (cont.)

– Financial and social information is used to Financial and social information is used to control conflicting demands of various control conflicting demands of various stakeholder groups.stakeholder groups.

Stakeholder theory (either branch) does Stakeholder theory (either branch) does not prescribe what information should be not prescribe what information should be disclosed, other than indicating that disclosed, other than indicating that provision of information can be useful for provision of information can be useful for the continued operations of the entity.the continued operations of the entity.



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Legitimacy theoryLegitimacy theory

Organisations continually seek to ensure Organisations continually seek to ensure that they operate within the bounds and that they operate within the bounds and norms of their respective societies.norms of their respective societies.

Organisations attempt to ensure their Organisations attempt to ensure their activities are perceived to be legitimate.activities are perceived to be legitimate.

Bounds and norms change across time.Bounds and norms change across time. Based on a ‘social contract’ between Based on a ‘social contract’ between

society and the organisation.society and the organisation.



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Legitimacy theory Legitimacy theory (cont.)(cont.) Organisations must appear to consider Organisations must appear to consider

the rights of the public at large, not the rights of the public at large, not just investors.just investors.

To gain or maintain legitimacy, To gain or maintain legitimacy, organisations may rely on disclosure organisations may rely on disclosure within the annual report.within the annual report.



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Theories explaining Theories explaining why regulation is why regulation is introducedintroduced

Public interest theoryPublic interest theory Capture theoryCapture theory Economic interest group theoryEconomic interest group theory



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Public interest theoryPublic interest theory

Regulation put in place to benefit Regulation put in place to benefit society as a whole, rather than vested society as a whole, rather than vested interests.interests.

Regulatory body considered to Regulatory body considered to represent interests of the society in represent interests of the society in which it operates, rather than private which it operates, rather than private interests of the regulators.interests of the regulators.

Assumes that government is a neutral Assumes that government is a neutral arbiter.arbiter.



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Capture theoryCapture theory

The regulated seeks to take charge The regulated seeks to take charge of (capture) the regulator.of (capture) the regulator.

Seek to ensure rules subsequently Seek to ensure rules subsequently released are advantageous to the released are advantageous to the parties subject to regulation.parties subject to regulation.

Although regulating initially in the Although regulating initially in the public interest, difficult for public interest, difficult for regulator to remain independent.regulator to remain independent.



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Economic interest group Economic interest group theorytheory Assumes groups will form to protect Assumes groups will form to protect

particular economic interests.particular economic interests. Groups are often in conflict with each Groups are often in conflict with each

other, and will lobby government to other, and will lobby government to put in place legislation which will put in place legislation which will benefit them at the expense of others.benefit them at the expense of others.

No notion of public interest inherent in No notion of public interest inherent in the theory.the theory.

Regulators (and all other individuals) Regulators (and all other individuals) deemed to be motivated by self-deemed to be motivated by self-interest.interest.



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Economic interest group Economic interest group theory (cont.)theory (cont.) The regulator is not a neutral arbiter but The regulator is not a neutral arbiter but

is seen as an interest group.is seen as an interest group. Regulator motivated to ensure re-election Regulator motivated to ensure re-election

or maintenance of its position of power.or maintenance of its position of power. Regulation serves the private interests of Regulation serves the private interests of

politically effective groups.politically effective groups. Those groups with insufficient power will Those groups with insufficient power will

not be able to effectively lobby for not be able to effectively lobby for regulation to protect their own interests.regulation to protect their own interests.



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Critical theoryCritical theory Dissatisfaction with Positive Theory (PT) Dissatisfaction with Positive Theory (PT)

has led to the advocation of a critical has led to the advocation of a critical approach to the development of approach to the development of knowledge and understanding in knowledge and understanding in accounting.accounting.

Goal of critical theory is to provide a Goal of critical theory is to provide a measure for understanding ‘reality’ and measure for understanding ‘reality’ and the development of a society that will the development of a society that will enable a ‘truer freer and more just life for enable a ‘truer freer and more just life for all’.all’.



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Critical theory and its Critical theory and its application to application to accountingaccounting It recognises the primacy of social It recognises the primacy of social

relationships over the technincal relationships over the technincal approach.approach.

Greater cognisance is taken of Greater cognisance is taken of underlying cultural elements, which underlying cultural elements, which are blendedare blendedinto the research and methodology into the research and methodology used in accounting.used in accounting.



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Critical theory and its Critical theory and its application to application to accounting (cont.)accounting (cont.) It provides the justification for the It provides the justification for the

use of non scientific methodologies use of non scientific methodologies in accounting research.in accounting research.



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Critical theory Critical theory concludedconcluded Its strength is the thorough Its strength is the thorough

epistemological standards imposed epistemological standards imposed upon the researcher.upon the researcher.

It provides an alternative device or It provides an alternative device or way forward and avoids many of the way forward and avoids many of the problems of positivitism.problems of positivitism.

Documents

Chapter 2 Theories of financial accounting. Copyright 2003 McGraw-Hill New Zealand Pty Ltd PPTs t/a New Zealand Financial Accounting 2e by Deegan and