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3-1Copyright 2007 McGraw-Hill Australia Pty Ltd

Chapter 3

Theories of financial

accounting


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Objectives

• Be able to describe various normative and positivetheories of financial accounting

• Be aware of some of the limitations of the various

theories of accounting

• Appreciate that there is no single unified theory ofaccounting

• Understand the various pressures and motivations that

might have an effect on the methods of accounting

selected by an organisation• Understand what is meant by ‘creative accounting’ and

why it might occur


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Theory definition

• A coherent group of propositions or principles forminga general framework of reference for a field of inquiry

• Accounting theories explain and predict accounting

practice positive theories! or prescribe particular

practice normative theories!


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3-'Copyright 2007 McGraw-Hill Australia Pty Ltd

Positive Accounting Theory (PAT)

• "ositive Accounting #heory is an example of anexample of a positive theory of accounting$ As we willsee later% there are other positive theories ofaccounting as well as normative theories ofaccounting!

• "A# &xplains and predicts accounting practice• 'oes not seek to prescribe particular actions

• (rounded in economic theory

• )ocuses on the relationships between various

individuals involved in providing resources to anorganisation agency relationship! * owners and managers

* managers and debt providers


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(cont.)

Agency theory• Agency relationship

* delegation of decision making from the principal to the agent

• Agency problem

* delegation of authority can lead to loss of efficiency andincreased costs

• Agency costs

* costs that arise as a result of the agency relationship


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(cont.)

Agency costs• +onitoring costs

• Bonding expenditures

• ,esidual loss


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(cont.)

Assumptions of "A#• All individual action is driven by self-interest do we

think this is a realistic assumption.!

• /ndividuals will act in an opportunistic manner to

increase their wealth• 0otions of loyalty and morality are not incorporated

within the theory

• 1rganisations are a collection of self-interested

individuals who agree to cooperate to the extent it is intheir interest


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(cont.)

"A# predictions• 1rganisations will seek to put in place mechanisms

to align the interests of managers of the firm agents!

with the interests of the owners principals!

• 2ome of these mechanisms rely on the output of theaccounting system

* for example% the owners might agree to pay the manager a

bonus based on a specified percentage of profits


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(cont.)

&fficiency and opportunistic perspectives of "A#• &fficiency perspective

* mechanisms are put in place up front with the ob3ective of minimisingfuture agency costs )or example% reward structures might be implemented to motivate and

retain managers% perhaps by providing them with bonuses tied toaccounting profits% or providing them with shares or options

4oluntary audits might be undertaken to reduce the perceived risks ofinvestors

* referred to as ex ante perspective * accounting methods adopted by firms best reflect the underlying

financial performance of the entity * might select the most efficientway to portray the performance of the entity

* regulation is therefore argued by "A# advocates to imposeunwarranted costs on reporting entities * causes the firm to providean inefficient perspective of the performance and position of theorganisation as it requires movement to a one-si5e-fits-all approachto reporting


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(cont.)

&fficiency and opportunistic perspectives of "A# cont$!• 1pportunistic perspective

* considers opportunistic actions that could be taken once

various contractual arrangements have been put in place

)or example% once a profit sharing scheme has been put in place

to motivate managers to increase the value of the organisationthat is% put in place for efficiency reasons!% managers will * to

the extent they can get away with it * be predicted to try to

manipulate reported profits so as to generate the greatest wealth

transfer to themselves

* assumes managers will opportunistically select accountingmethods to increase their own personal wealth


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(cont.)

1wner6+anager contracting

• +anagers assumed to act in their own self-interest

at the expense of owners

* ‘,ational economic person’ assumption• +anagers have access to information not available

to principals

* /nformation asymmetry


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(cont.)

1wner6+anager contracting cont$!

• +ethods of reducing agency costs of equity

* price protection

*monitoring by owners

* bonding by managers

* managers may be rewarded7

on a fixed basis

on the basis of the results achieved

on a basis that combines the two


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(cont.)

Bonus schemes• ,emuneration based on the output of the accounting

system

• 4ery common and their existence can be explained by

"A#• Bonuses might be based on7

* profits of the firm

* sales of the firm

* return on assets• +ay also be rewarded based on market price of

shares


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2007 McGraw-Hill Australia Pty Ltd


(cont.)

Accounting-based bonus schemes

• Any changes in the accounting methods used by the

organisation will affect the bonuses paid e$g$ as a

result of a new accounting standard!

• 8hanging the bonuses paid impacts cash flows% andthis in turn is predicted to impact the value of the

organisation

• 8ontracts may rely on ‘floating’% generally accepted

accounting principles


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(cont.)

/ncentives to manipulate accounting numbers

• ,ewarding managers on the basis of accounting

profits can induce them subsequently to manipulate

the related accounting numbers to improve theirapparent performance and thus the related rewards

• Accounting profits might not always provide an

unbiased measure of a firm’s performance * so also

common to find the use of share-based reward

structures% which in certain circumstances% might be

deemed to be more efficient


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(cont.)

+arket-based bonus schemes

• +arket prices are assumed to be influenced by

expectations about the net present value of

expected future cash flows• 8ash bonuses might be awarded on the basis of

increases in share prices

• 2hares or options to shares might also be provided


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(cont.)

+arket-based bonus schemes

• +arket prices reflect market-wide factors% not 3ust

those factors controlled by the manager

• 1nly senior management will be likely to be able toaffect cash flows and hence securities prices


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(cont.),ole of auditor • /f managers’ remuneration is based on accounting

numbers the auditor takes a monitoring role

• #he auditor arbitrates on the reasonableness of the

accounting methods adopted• 2ome research indicates that the greater the

separation between managers and owners% and the

greater the reliance on external debt meaning greater

potential agency costs!% the greater the likelihood thatvoluntary financial statements would be undertaken


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(cont.)

1ther mechanisms that align the interests of managers

and owners

• #hreat of takeovers to underperforming firms

• A well-informed labour market


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(cont.)'ebt contracting

• Agency costs of debt7

* excess dividends

* claim dilution

* asset substitution

* investment in risky pro3ects

• 9hen discussing the agency costs of debt it is

assumed that the managers’ interests are aligned with

the shareholders’ interests


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(cont.)

9ays to minimise the agency costs of debt

• "rice protection

* higher interest charges to compensate for risk

• 8ontracting * interest coverage clauses

* debt to asset clauses

:everage clauses frequently used in Australian bank loan

contracts

• +onitoring


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(cont.)"olitical costs

• 8osts that groups external to the firm might be able to impose onthe firm7 * increased taxes

* increased wage claims

* product boycotts * decreased subsidies

• 1rganisations are affected by governments% trade unions%environmental lobby groups or particular consumer groups


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(cont.)"olitical costs cont$!• 'emands placed on the firm might be affected by

accounting results

* higher reported profits

* how accounting numbers are generated is not important

• Accounting numbers might be used as a means of

providing ‘excuses’ for effecting wealth transfers in the

political process


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(cont.)

9ays to reduce political costs

• +anagement might7

* adopt income-reducing accounting techniques

* make voluntary social disclosures


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Discussion leads to 3 ain hypotheses of

PAT

• The bonus plan hypothesis is that managers of firmswith bonus plans are more likely to use accounting

methods that increase current period reported income.

• The debt/equity hypothesis predicts that the higher the

firm’s debt/equity ratio, the more likely managers use

accounting methods that increase income.

• The political cost hypothesis predicts that large firms

rather than small firms are more likely to use

accounting choices that reduce reported profits.


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PAT in suary

• 2election of accounting methods can be explained by eitherefficiency or opportunistic arguments

• Accounting methods can impact on cash flows associated with

debt and management compensation contracts

• #hese effects can be used to explain why particular accounting

methods are used• #he use of particular accounting methods can have conflicting

effects


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Accounting policy selection

and disclosure

• #o allow comparison between reporting entities

* a summary of accounting policies must be presented in the

notes to the financial report AA2B ;


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Accounting policy selection

and disclosure (cont.)

Accounting policy choice and ‘creative accounting’

• ‘8reative accounting’ refers to selecting accounting

methods that provide the result desired by the

preparers

• Also known as opportunistic

• 8an be explained by "A#

• /t is possible to be creative and still follow

accounting standards


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Criticiss of PAT

• 'oes not provide prescription so does not provide a means of

improving accounting practice

• 0ot value-free but rather value-laden

• Underlying assumption of wealth maximisation is simplistic

• /ssues being addressed have not shown any significant

development• 2cientifically flawed


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!orative accounting theories

• 2eek to provide guidance in selecting accounting

procedures that are most appropriate

• "rescribe what should be done


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!orative accounting theories ( cont.)

#he 8onceptual )ramework7• is considered a normative theory

• seeks to identify the ob3ective of ("),

• seeks to provide recognition and measurement rules

within a ‘coherent’ and ‘consistent’ framework• identifies the qualitative characteristics financial

information should possess

• makes recommendations that depart from current

practice


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1ther normative theories• #hree main classifications

;$ current-cost accounting

>$ exit-price accounting

@$ deprival-value accounting

• #hese theories addressed issues associated with

changing prices

• 'eveloped in ;?


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8urrent-cost accounting• Aim is to provide a calculation of income that% after

ad3usting for changing prices% can be withdrawn from

the entity and still leave the physical capital operating

capacity! of the entity intact

* referred to as true measure of income

• #rue income theories propose a single measurement

basis for assets and a resultant single measure of

income profit!


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&xit-price accounting

• 8ontinuously 8ontemporary Accounting

• Uses exit or selling prices to value the entity’s assets and

liabilities

* referred to as current cash equivalents

• Assumptions7 * firms exist to increase the wealth of their owners

* the ability to adapt to changing circumstances

* capacity to adapt best reflected by current selling prices


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'eprival-value accounting• 'eprival value represents the amount of loss thatmight be incurred by an entity if it were deprived of theuse of an asset and the associated economic benefits

• #his method considers7

* the net selling price

* the present value of future cash flows

* an asset’s current replacement cost


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"ystes#oriented theories

2ystems-oriented theories• #hese theories focus on the role of information and

disclosure in the relationships betweenorganisations% the 2tate% individuals and groups

• #he entity is assumed to be influenced by thesociety in which it operates and to have an influenceon it

• 2ystems-based theories include7 * stakeholder #heory

* legitimacy #heory

* institutional #heory


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"ystes#oriented theories (cont.)

2takeholder #heory

• #wo branches

;$ &thical normative! branch

>$ +anagerial positive! branch

• &thical normative! branch * stakeholders are any group or individual who can affect or are

affected by the achievement of the firm’s ob3ectives

* includes shareholders% employees% customers% lenders%suppliers% local charities% interest groups% government% etc$

* all stakeholders have a right to be provided with information

* because it prescribes how stakeholders should be treated based

on various ethical perspectives!% it is a normative approach


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2takeholder #heory cont$!

• +anagerial positive! branch

* seeks to explain and predict how an organisation will react to

demands of various stakeholders

* relative power or importance of stakeholders considered

* relative power and importance can change across timeCassociated

with control of resources

* the firm will take actions to ‘manage’ its relationships with

stakeholders


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2takeholder #heory cont$!• 2takeholder #heory either branch! does not prescribe

what information should be disclosed% other than

indicating that the provision of information can be

useful for the continued operations of the entity

• +anagerial branch cont$!

* financial and social information is used to control conflicting

demands of various stakeholder groups


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:egitimacy #heory• 1rganisations continually seek to ensure that they

operate within the bounds and norms of society

• 1rganisations attempt to ensure their activities are

perceived to be legitimate• Bounds and norms change across time

• Based on a ‘social contract’ between society and the

organisation

• 9here this social contract is perceived as beingbreached then the organisation will take corrective

action% and this action might include disclosure


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:egitimacy #heory cont$!• 1rganisations must appear to consider the rights of

the public at large% not 3ust investors

• #o gain or maintain legitimacy% organisations might rely

on disclosure within their annual report


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/nstitutional #heory

• &xplains why organisations within particular ‘fields’ tend to take

on similar characteristics and form

• +uch overlap with :egitimacy #heory and 2takeholder #heory

• #wo main dimensions to the theory * isomorphism and

decoupling• /somorphism

* coercive

* mimetic

* normative

• 'ecoupling * actual practices can be very different from formally sanctioned and

publicly pronounced processes and practices


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Theories e$plaining %hy regulation

is introduced

• Dust as there are theories to explain why particular

accounting disclosures are made "A#% :egitimacy

#heory% 2takeholder #heory!% or why particular

organisational forms exist institutional theory!% there

are also theories to explain why particularregulations for example% accounting regulations!

are developed$ 2uch theories include7

* "ublic interest theory

* 8apture theory * &conomic interest group theory


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Theories e$plaining %hy regulation is

introduced (cont.)

"ublic interest theory

• ,egulation put in place to benefit society as a whole

rather than vested interests

• ,egulatory body considered to represent the interests

of the society in which it operates% rather than theprivate interests of the regulators

• Assumes that government is a neutral arbiter


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introduced (cont.)

8apture theory

• #he regulated seeks to take charge capture! the

regulator

• #hey seek to ensure rules subsequently released are

advantageous to the parties sub3ect to regulation


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introduced (cont.)

&conomic interest group theory

• Assumes groups will form to protect particulareconomic interests

• (roups are often in conflict with each other and will

lobby government to put in place legislation that willbenefit themat the expense of others

• 0o notion of public interest inherent in the theory

• ,egulators and all other individuals! deemed to bemotivated by self-interest


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introduced (cont.)

&conomic interest group theory cont$!• #he regulator is not a neutral arbiter but is seen as an interest

group

• ,egulator is motivated to ensure re-election or maintenance of itsposition of power

• ,egulation serves the private interests of politically effectivegroups

• #hose groups with insufficient power will not be able to lobbyeffectively for regulation to protect their own interests


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"uary

• #he chapter describes various theories that relate to financial

accounting• 0o single accounting theory is universally accepted

• "ositive #heory of Accounting

* seeks to explain and predict accounting-related phenomena

* e$g$ study of capital market’s reaction to particular accounting

policies% what motivates managers to select a given method

of accounting% reasons for the existence of particular

accounting-based contracts

* relies upon a fundamental assumption that individual action

can be predicted on the basis that all action is driven by a

desire to maximise wealth a perspective often criticised byother researchers!


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"uary (cont.)

0ormative theories of accounting

* prescribe how accounting should be practised * argue typically that a central role of accounting theory is

to provide prescriptionCinform about optimal accountingapproaches and why a particular approach is consideredoptimal

* examples7 8onceptual )ramework "ro3ect% current-costaccounting% exit-price accounting and deprival-valueaccounting


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"uary (cont.)

2ystems-based theories

• /nclude 2takeholder #heory% :egitimacy #heory% and /nstitutional

#heory

* see organisation as firmly embedded within a broader social

system

* organisation is considered to be affected by% and to affect% thesociety in which it operates

* accounting disclosures and particular organisational forms are

seen as a way to manage relations with particular groups

outside the organisationC organisational activities and

accounting disclosures are considered to be reactive tocommunity pressuresChow a firm operates and what it

reports must be determined upon consideration of various

stakeholder expectations


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"uary (cont.)

#heories that seek to explain how regulation is

developed• 2ome theories suggest that regulation is introduced to

serve the public interest by regulators who work for thepublic good

• 1ther theories of regulation assume that the development

of regulation is driven by considerations of self-interest• 1verall% the selection of one theory over another will

depend on the views and expectations of the researcherin question

• 0o one theory of accounting can be described as a ‘best’theoryChowever% different theoretical perspectives can at

various times provide valuable insights in accountingissues

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