ACCT5943 Advanced Financial Reporting
Accounting Theories
Reference readings
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TEXTBOOK:
• Deegan Chapter 3
Non-examinable sections: Sections 3.9 (pp125-128) and 3.14
• Deegan Section 2.12
• Understand what constitutes a ‘theory’
• Describe agency theory including the notion of agency costs
• Understand the central tenets of Positive Accounting Theory
• Understand that from a Positive Accounting Theory perspective, accounting based measures are often used to
resolve conflicts between managers and owners and managers and debt-holders
• Explain the implications of Positive Accounting Theory to accounting policy choice and accounting judgments
• Analyse political costs as an explanation for accounting policy choice
• Introduce other factors that may influence an entity’s reporting behaviours as predicted by systems- orientated
theories, including stakeholder, legitimacy and institutional theory
Learning Objectives
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Theory definition
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• 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
• Systems-oriented theories
Positive Accounting Theory (PAT 1)
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• Tries to explain (or predict) existing accounting practices
• Does not necessarily deal with what should occur
according to accounting standards and the Conceptual
Framework
• What should occur was covered in ACCT5942 and will also
be covered in different topics in this course
• Most large businesses in Australia have separation between
management and providers of equity and debt financing
(shareholders and lenders)
• In other countries, there is separation between inside
shareholders and outside equity and debt holders
• For example, in Asia many companies are controlled by
family groups, but also have many outside shareholders
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Positive Accounting Theory (PAT 2)
• A fundamental assumption is that individuals act in self-interest – that is
in a way that will ensure their own personal wealth maximisation
• For this reason another key assumption is that shareholders and lenders
will put in place mechanisms to align the interests of the managers to
their interests
• Some of these mechanisms will be based on the output of the
accounting system – for example linking the managers bonus to the
profits of the company
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Positive Accounting Theory (PAT 3)
Conflicts of interest arise between the manager and the shareholder:
• Differences in risk aversion
• Horizon problem
• Insiders have short term focus; outsiders have long term focus
• Shirking
• Over-retention of profits
• Insiders tunnel firm’s funds to themselves
• How? Non-arms length transactions/fraud/consumption of
excessive perquisites
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Positive Accounting Theory (PAT 4)
• Conflicts also arise between the manager and the lender
• Insiders try to maximise the value of equity rather than the value of the firm (debt +
equity)
• Examples:
• Excessive dividend payments
• Claim dilution
• Asset substitution
• Underinvestment
• Excessive management perquisites and shirking can also be considered agency costs of
debt if they lead to debt default
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Positive Accounting Theory (PAT 5)
Positive Accounting Theory (PAT 6)
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• In perfect markets, these agency conflicts would be costlessly
eradicated
• With imperfect markets, we have
• Positive transactions costs
• Information asymmetry (insiders know more than outsiders
about the firm)
… leads to residual agency problems
Positive Accounting Theory (PAT 7)
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• From these residual agency problems we get:
• Demand for accounting and auditing
• Incentives to choose accounting policies systematically among firms
• Residual agency problems include:
• Agency costs of equity
• Agency costs of debt
• Who bears these costs?
• They are shared between insiders and outsiders because the outsiders
cannot estimate them accurately
Positive Accounting Theory (PAT 8)
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• Agency Costs of Equity result from a trade off between:
• Decline in value of firm due to manager’s shirking and other conflicts with
outsiders; and
• Monitoring and bonding costs incurred to reduce the manager’s shirking etc.
behaviour
• Agency Costs of Debt result from trade off between:
• Decline in value of debt due to manager’s attempts to shift wealth from debt-
holders to equity-holders; and
• Monitoring and bonding costs incurred to reduce that behaviour
Positive Accounting Theory (PAT 9)
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• Therefore, agency costs =
1. Costs of monitoring and bonding
+
2. Residual loss due to manager’s adverse actions
against capital-holders that monitoring and bonding
cannot stop because the cost to do so is too high
Agency Costs of Equity (PAT 10)
Monitoring and bonding mechanisms
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• Financial reporting
• Management compensation (bonus) plans
• Auditing (external & internal)
• Corporate governance - eg. audit committees, independent directors
• Market for corporate control (takeovers)
• Managerial labour market
Agency Costs of Debt (PAT 11)
Monitoring and bonding mechanisms
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• Restrictive covenants on borrowing
• Monitoring (via general and specific financial reports)
• Debt-holders have a member on board of directors
and remuneration committee
• Dividend restrictions
Political Costs (PAT 12)
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• Refers to the possibility that the firm will have wealth transferred from it
by governments or actions of special interest groups
• Examples:
• Loss of special concessions
• Increased taxes (mining super profits tax; carbon tax)
• Government investigations
• Adverse publicity in the media
Role of accounting in monitoring and
bonding (PAT 13)
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• Contracts often contain accounting hurdles
• Reported financial information to monitor contracts
• Not all accounting methods can be specified in contracts,
so managers have some discretion = part of the residual
loss
=> Choice of accounting method has
economic consequences
PAT & accounting policy choice
predictions (PAT 14)
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Watts & Zimmerman’s (1990) hypotheses:
(1) Bonus Plan
Managers adopt income increasing methods if their compensation is linked to
accounting profit
(2) Debt covenant
Managers adopt income increasing accounting methods if debt covenants limit
borrowings via accounting numbers, eg. max debt/asset ratio
(3) Political Cost
Large firms prefer income decreasing methods to minimise political costs
Economic consequences of accounting
policy choice (PAT 15)
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Managers have incentives to adopt certain accounting policies, two
perspectives:
1. Efficiency perspective
– managers choose accounting methods that maximise firm value
(minimise agency costs)
2. Opportunistic perspective
– managers choose accounting methods that maximise their own
welfare
Economic consequences of accounting policy
choice – Efficiency perspective (PAT 16)
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• Managers choose accounting methods that maximise firm value (by
minimising agency costs)
• All contracting parties want these accounting methods although perhaps
for different reasons
• Method will be specified in contracts
• Does not form part of the residual loss
• Should reflect economic reality of the firm
Economic consequences of accounting policy
choice – Opportunistic perspective (PAT 17)
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• Contracts are already in place
• Managers (insiders) are permitted to exercise some discretions in
accounting choices which they take advantage of
• Opportunistic choices form part of the “residual loss”
• Examples of opportunism:
• Changing depreciation method from reducing balance to straight line
on new assets to reduce depreciation expense
• Accelerating revenue recognition to increase profits and increase
bonuses
• Revaluing fixed assets to reduce leverage
Criticisms of PAT (PAT 18)
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• Being non-prescriptive it is of little benefit in improving accounting
practice
• Is not value free but is value laden
• Scientifically flawed & lacks development
• Questionable underlying assumptions - e.g. self-interest & market
efficiency
• Ignores other important factors - e.g. the law (except as a constraint),
reputation, ethics and morality, social responsibility
Systems-oriented theories (SOT 1)
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• Apart from PAT there are other theories applicable to the
accounting process
• Systems-oriented theories focus on the role of information
and disclosure in the relationships between organisations, the
government, individuals and groups
• The entity is assumed to be influenced by the society in which
it operates and to have an influence on it (see diagram on
following slide)
Systems-oriented theories (SOT 2)
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Systems-oriented theories include:
1. Stakeholder Theory
2. Legitimacy Theory
3. Institutional Theory
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Systems-oriented theories (SOT 3)
Two branches:
1) Ethical (normative) branch; and
2) Managerial (positive) branch
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Stakeholder theory (SOT 4)
The 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, future generations and the
environment
• All stakeholders have a right to be provided with information about how the
organisation is affecting them (eg via pollution, community sponsorship,
safety initiatives etc)
• Because it prescribes how stakeholders should be treated (based on various
ethical perspectives) it is a normative approach
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Stakeholder theory (SOT 5)
Managerial (positive) branch
• Seeks to explain and predict how an organisation will react to demands of
various stakeholders
• Relative power or importance of stakeholders are considered
• The firm will take actions to ‘manage’ its relationships with stakeholder
• Financial and social information is used to control conflicting demands of
various stakeholder groups
• Management will respond to the information demands of stakeholders
perceived as being powerful
• If a stakeholder group does not have power then their information demands
might not be met
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Stakeholder theory (SOT 6)
• Neither branch prescribes what information should be disclosed, other than
indicating that the provision of information can be useful for the continued
operations of the entity.
• By applying stakeholder theory, regulators can gain an understanding of why
some disclosures are being voluntarily made by organisations while other
seemingly important disclosures are not being made.
• This has implications for the need to potentially legislate particular disclosures.
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Relevance of stakeholder theory to
accounting (SOT 7)
• 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
• Organisations must appear to consider the rights of the
public at large, not just investors
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Legitimacy theory (SOT 8)
• Based on a ‘social contract’ between the 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
• To gain or maintain legitimacy, organisations might rely on disclosure
within their annual report or in other forms
• If an organisation cannot justify it’s continued operations then the
society may ‘revoke’ the social contract
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Legitimacy theory (SOT 9)
• Much overlap between legitimacy theory and stakeholder
theory
• Both theories explicitly consider the organisation in it’s
broader social context
• These theories do not rely on assumption of self-interest
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Stakeholder and legitimacy theory vs
PAT (SOT 10)
• Explains why organisations within particular ‘fields’ tend to take on
similar characteristics and form.
• DiMaggio and Powell (1983) identified two main dimensions to the
theory of central relevance to explaining voluntary corporate reporting
practices:
1. Isomorphism - a constraining process that forces one unit in a
population to resemble other units that face the same set of
environmental conditions.
2. Decoupling - actual practices can be very different from formally
sanctioned and publicly pronounced processes and practices.
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Institutional theory (SOT 11)
DiMaggio and Powell (1983) set out three isomorphic processes:
1. Coercive isomorphism: organisation is coerced by its influential stakeholders
into adopting particular reporting practices
2. Mimetic isomorphism: organisation seeks to mimic the institutional practices
of other organisations, for reasons of competitive advantage in terms of
legitimacy
3. Normative isomorphism: organisation is pressured under group norms to
adopt particular institutional practices, to produce accounting reports that are
shaped by accounting standards; group norms include informal forms such as
the culture and working practices developed within the workplace
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Institutional theory (SOT 12)
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Conclusion
The Positive Accounting Theory and the
Systems-Oriented Theories provide insightful
theoretical rationale and predictions to help us
understand firms’ reporting behaviours, and
their choice of accounting and non-accounting
methods.