deegan5e ch03

3-1 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig DeeganSlides prepared by Craig Deegan

Chapter 3

Theories of financial accounting


Objectives

• Be able to describe various normative and positive theories of financial accounting

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

• Appreciate that there is no single unified theory of accounting

• 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


Theory definition

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

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


Positive Accounting Theory (PAT)

• Positive Accounting Theory is an example of an example of a positive theory of accounting. As we will see later, there are other positive theories of accounting (as well as normative theories of accounting)

• PAT Explains and predicts accounting practice• Does not seek to prescribe particular actions• Grounded in economic theory• Focuses on the relationships between various

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


Positive Accounting Theory (PAT) (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 and

increased costs

• Agency costs– costs that arise as a result of the agency relationship



Agency costs• Monitoring costs• Bonding expenditures• Residual loss



Assumptions of PAT• All individual action is driven by self-interest (do we

think this is a realistic assumption?)• Individuals will act in an opportunistic manner to

increase their wealth• Notions of loyalty and morality are not incorporated

within the theory• Organisations are a collection of self-interested

individuals who agree to cooperate to the extent it is in their interest



PAT predictions• Organisations will seek to put in place mechanisms

to align the interests of managers of the firm (agents) with the interests of the owners (principals)

• Some of these mechanisms rely on the output of the accounting system– for example, the owners might agree to pay the manager a

bonus based on a specified percentage of profits



Efficiency and opportunistic perspectives of PAT• Efficiency perspective

– mechanisms are put in place up front with the objective of minimising future agency costs

For example, reward structures might be implemented to motivate and retain managers, perhaps by providing them with bonuses tied to accounting profits, or providing them with shares or options

Voluntary audits might be undertaken to reduce the perceived risks of investors

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

financial performance of the entity – might select the most efficient way to portray the performance of the entity

– regulation is therefore argued by PAT advocates to impose unwarranted costs on reporting entities – causes the firm to provide an inefficient perspective of the performance and position of the organisation as it requires movement to a one-size-fits-all approach to reporting



Efficiency and opportunistic perspectives of PAT (cont.)• Opportunistic perspective

– considers opportunistic actions that could be taken once various contractual arrangements have been put in place

For example, once a profit sharing scheme has been put in place to motivate managers to increase the value of the organisation (that 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 accounting methods to increase their own personal wealth



Owner/Manager contracting• Managers assumed to act in their own self-interest

at the expense of owners– ‘Rational economic person’ assumption

• Managers have access to information not available to principals– Information asymmetry



Owner/Manager contracting (cont.)• Methods of reducing agency costs of equity

– price protection– monitoring by owners– bonding by managers– managers may be rewarded:

on a fixed basis on the basis of the results achieved on a basis that combines the two



Bonus schemes• Remuneration based on the output of the accounting

system• Very common and their existence can be explained by

PAT• Bonuses might be based on:

– profits of the firm– sales of the firm– return on assets

• May also be rewarded based on market price of shares



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)

• Changing the bonuses paid impacts cash flows, and this in turn is predicted to impact the value of the organisation

• Contracts may rely on ‘floating’, generally accepted accounting principles



Incentives to manipulate accounting numbers• Rewarding managers on the basis of accounting

profits can induce them subsequently to manipulate the related accounting numbers to improve their apparent 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



Market-based bonus schemes• Market prices are assumed to be influenced by

expectations about the net present value of expected future cash flows

• Cash bonuses might be awarded on the basis of increases in share prices

• Shares or options to shares might also be provided



Market-based bonus schemes• Market prices reflect market-wide factors, not just

those factors controlled by the manager• Only senior management will be likely to be able to

affect cash flows and hence securities prices



Role of auditor• If managers’ remuneration is based on accounting

numbers the auditor takes a monitoring role• The auditor arbitrates on the reasonableness of the

accounting methods adopted• Some 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 that voluntary financial statements would be undertaken



Other mechanisms that align the interests of managers and owners

• Threat of takeovers to underperforming firms• A well-informed labour market



Debt contracting• Agency costs of debt:

– excess dividends– claim dilution– asset substitution– investment in risky projects

• When discussing the agency costs of debt it is assumed that the managers’ interests are aligned with the shareholders’ interests



Ways to minimise the agency costs of debt• Price protection

– higher interest charges to compensate for risk

• Contracting– interest coverage clauses– debt to asset clauses

Leverage clauses frequently used in Australian bank loan contracts

• Monitoring



Political costs• Costs that groups external to the firm might be able to impose on

the firm:– increased taxes– increased wage claims– product boycotts– decreased subsidies

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



Political costs (cont.)• Demands 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



Ways to reduce political costs• Management might:

– adopt income-reducing accounting techniques– make voluntary social disclosures


Discussion leads to 3 main hypotheses of PAT

• The bonus plan hypothesis is that managers of firms with 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.


PAT in summary

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

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

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

• The use of particular accounting methods can have conflicting effects


Accounting policy selection and disclosure

• To allow comparison between reporting entities– a summary of accounting policies must be presented in the

notes to the financial report (AASB 101, par. 108)– where an accounting policy has changed and the change has

a material effect on results the notes must disclose the nature of, reason for, and financial effect of the change (AASB 108, par. 29)


Accounting policy selection and disclosure (cont.)

Accounting policy choice and ‘creative accounting’• ‘Creative accounting’ refers to selecting accounting

methods that provide the result desired by the preparers

• Also known as opportunistic • Can be explained by PAT• It is possible to be creative and still follow

accounting standards


Criticisms of PAT• Does not provide prescription so does not provide a means of

improving accounting practice• Not value-free but rather value-laden• Underlying assumption of wealth maximisation is simplistic• Issues being addressed have not shown any significant

development• Scientifically flawed


Normative accounting theories• Seek to provide guidance in selecting accounting

procedures that are most appropriate• Prescribe what should be done


Normative accounting theories ( cont.)

The Conceptual Framework:• is considered a normative theory• seeks to identify the objective of GPFR• 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



Other normative theories• Three main classifications

1. current-cost accounting

2. exit-price accounting

3. deprival-value accounting

• These theories addressed issues associated with changing prices

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



Current-cost accounting• Aim is to provide a calculation of income that, after

adjusting 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

• True income theories propose a single measurement basis for assets and a resultant single measure of income (profit)



Exit-price accounting• Continuously Contemporary Accounting• Uses exit or selling prices to value the entity’s assets and

liabilities– referred to as current cash equivalents

• Assumptions:– 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



Deprival-value accounting • Deprival value represents the amount of loss that

might be incurred by an entity if it were deprived of the use of an asset and the associated economic benefits

• This method considers:– the net selling price– the present value of future cash flows– an asset’s current replacement cost


Systems-oriented theories

Systems-oriented theories• These theories focus on the role of information and

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

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

• Systems-based theories include:– stakeholder Theory– legitimacy Theory– institutional Theory


Systems-oriented theories (cont.)

Stakeholder Theory• Two branches

1. Ethical (normative) branch2. Managerial (positive) branch

• Ethical (normative) branch– stakeholders are any group or individual who can affect or are

affected by the achievement of the firm’s objectives– 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



Stakeholder Theory (cont.)• Managerial (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 time—associated with control of resources

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



Stakeholder Theory (cont.)• Stakeholder Theory (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

• Managerial branch (cont.)– financial and social information is used to control conflicting

demands of various stakeholder groups



Legitimacy Theory• Organisations continually seek to ensure that they

operate within the bounds and norms of society• Organisations 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• Where this social contract is perceived as being

breached then the organisation will take corrective action, and this action might include disclosure



Legitimacy Theory (cont.)• Organisations must appear to consider the rights of

the public at large, not just investors• To gain or maintain legitimacy, organisations might

rely on disclosure within their annual report



Institutional Theory• Explains why organisations within particular ‘fields’ tend to take

on similar characteristics and form• Much overlap with Legitimacy Theory and Stakeholder Theory• Two main dimensions to the theory – isomorphism and

decoupling• Isomorphism

– coercive

– mimetic

– normative

• Decoupling– actual practices can be very different from formally sanctioned and

publicly pronounced processes and practices


Theories explaining why regulation is introduced

• Just as there are theories to explain why particular accounting disclosures are made (PAT, Legitimacy Theory, Stakeholder Theory), or why particular organisational forms exist (institutional theory), there are also theories to explain why particular regulations (for example, accounting regulations) are developed. Such theories include:– Public interest theory– Capture theory– Economic interest group theory


Theories explaining why regulation is introduced (cont.)

Public interest theory• Regulation put in place to benefit society as a whole

rather than vested interests• Regulatory body considered to represent the interests

of the society in which it operates, rather than the private interests of the regulators

• Assumes that government is a neutral arbiter



Capture theory• The regulated seeks to take charge (capture) the

regulator• They seek to ensure rules subsequently released are

advantageous to the parties subject to regulation



Economic interest group theory• Assumes groups will form to protect particular

economic interests• Groups are often in conflict with each other and will

lobby government to put in place legislation that will benefit them at the expense of others

• No notion of public interest inherent in the theory• Regulators (and all other individuals) deemed to be

motivated by self-interest



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

group• Regulator is motivated to ensure re-election or maintenance of its

position of power• Regulation serves the private interests of politically effective

groups• Those groups with insufficient power will not be able to lobby

effectively for regulation to protect their own interests


Summary

• The chapter describes various theories that relate to financial accounting

• No single accounting theory is universally accepted• Positive Theory 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 by other researchers)


Summary (cont.)

Normative theories of accounting– prescribe how accounting should be practised– argue typically that a central role of accounting theory is

to provide prescription—inform about optimal accounting approaches and why a particular approach is considered optimal

– examples: Conceptual Framework Project, current-cost accounting, exit-price accounting and deprival-value accounting


Summary (cont.)

Systems-based theories• Include Stakeholder Theory, Legitimacy Theory, and Institutional

Theory– see organisation as firmly embedded within a broader social

system– organisation is considered to be affected by, and to affect, the

society in which it operates– accounting disclosures and particular organisational forms are

seen as a way to manage relations with particular groups outside the organisation— organisational activities and accounting disclosures are considered to be reactive to community pressures—how a firm operates and what it reports must be determined upon consideration of various stakeholder expectations


Summary (cont.)Theories that seek to explain how regulation is

developed• Some theories suggest that regulation is introduced to

serve the public interest by regulators who work for the public good

• Other theories of regulation assume that the development of regulation is driven by considerations of self-interest

• Overall, the selection of one theory over another will depend on the views and expectations of the researcher in question

• No one theory of accounting can be described as a ‘best’ theory—however, different theoretical perspectives can at various times provide valuable insights in accounting issues

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