Garry Alberto E.

(1706058344)

Rio F. Kiantara (17060591132)

Nancy Hera Valeria (1706972934)

Jefri Jumadi Silaban (1706058382)

Chapter 11
POSITIVE THEORY OF ACCOUNTING POLICY AND DISCLOSURE

A. CONTRACTING THEORY
Contracting theory characterizes a company as the legal nexus (connection)
of the contractual relationship between suppliers and consumers of the factors of
production. Companies exist because this has a lower cost for individuals to transact
(or contract) through a central organization than to do it individually. In a more
general sense, rather than all suppliers of factors of production (land, labor and
capital) individually contracting with consumers for their output, it is better for this
contract to be taken by the company to connect between several classes of suppliers
and consumers. Coase argues that a company will exist because the company is the
most efficient form of the liaison contract (nexus) in regulating and coordinating
economic activities and reducing contract costs. Although it is important to
understand that companies involve contract multiplicity, positive accounting theory
usually focuses on two types of contracts, namely management contracts and debt
contracts. The two contracts are agency contracts, which in agency theory have
provided many explanatory sources for existing accounting practices.

B. AGENCY THEORY
Jensen and Meckling describe agent relations as arising where there is a
contract in which one party (principal) involves another party (agent) to perform
several services on behalf of the principal. Based on the contract, the principal
delegates several decision-making authorities to the agent. In a situation like this,
both the principal and the agent are those who will maximize their utility and there is
no reason to believe that the agent will always act in the best interests of the
principal. Agency problems that arise are problems to encourage the agent to act as
if he is maximizing the welfare of the principal. This agency problem will ultimately
lead to agency costs. At the most common level, agency costs represent the amount
(money) of a decline in welfare experienced by principals due to differences in
interests between principals and agents. Jensen and Meckling divided agency costs
into:
● monitoring costs (the cost of monitoring agent behavior)
● bonding costs (agency costs for making and complying with a mechanism that
ensures that the agent will behave in accordance with the interests of the
principal, or to ensure that the agent will compensate the principal if the agent
acts not in accordance with the interests of the principal)
● residual loss (costs to be borne and potential losses from long-term results on
the actions of agents that are not in accordance with the interests of the
principal.

C.​ ​PRICE PROTECTION AND SHAREHOLDER/MANAGER AGENCY PROBLEMS

Separation of ownership and control means that managers (as agents of
shareholders) can act in their own interests. But the agent's interests may conflict
with the interests of the shareholders. This problem was recognized in 1776, when
Adam Smith referred to The Wealth of Nations. Partial or non-ownership ownership
of a company by management provides an incentive for managers to behave in ways
that conflict with the interests of shareholders because management does not bear
the full costs of any dysfunctional behavior. The reason for the differences in
incentives related to company policy between shareholders and managers is a
specific problem. These problems include risk-aversion problems, dividend-retention
problems and problem horizons. The problem of risk-aversion means that managers
prefer smaller risks than shareholders. Shareholders have the capacity to diversify
their investment portfolios so that they are not risk-adverse to their investments in
certain companies. By investing in various companies (e.g. blue chip, mining,
industry) or other types of investments (such as stocks, property, commodities),
shareholders can minimize their chances of investing risks from one source.
Contracts can be used to reduce the adverse effects of this problem. One way
to do this is to tie the manager's remuneration to the stock price. Based on EMH, the
stock price reflects the interests and expectations of the owner (principal) about the
level of investment risk and all future cash flows for the continuity of the company.
Thus, it reflects market valuation of the development of the effects of wealth for
shareholders from the presence of risk-aversion preferences and management
dividends.

D. SHAREHOLDER-DEBTHOLDER AGENCY PROBLEMS

Smith and Warner acknowledge that agency problems with debt can develop
four main methods of transferring wealth from debt holders to shareholders:
● Excessive Dividend Payments ⇒ The problem of excessive dividend
payments arises when debts are lent to companies assuming certain rates of
dividend payments. Debt is valued accordingly, but the company then issues
a higher dividend rate. Publishing higher dividends reduces the asset base in
securing debt and reducing the value of debt.
● Asset Substitution ⇒ Asset substitution is based on the premise that lenders
will avoid risk (risk-averse). They provide loans to companies in the hope that
the loans will not be invested in assets or projects with a higher risk than they
can receive. They value debt accordingly, through the interest rate charged or
the term of the loan.
● Underinvestment ⇒ Underinvestment occurs when the owner has an
incentive not to carry out positive NPV projects because to do so will increase
funds available for debtholders, but not for the owner.
● Claim Dilution ⇒ Claim dilution occurs when the company issues debt of a
higher priority than the debt that has been issued. This increases the available
funds to increase company value and owner interest, but decreases the
relative security and value of existing debt. That is, deluding the value of
existing debt due to debt which has now become more risky with the
existence of higher priority debt.
E. EX POST OPPORTUNISM VERSUS EX ANTE EFFICIENT CONTRACTING
Contracting agencies provide incentives for agents to act in a manner that is
contrary to the interests of the principal. However, the existence of price protection
means that it is in the interests of the agent to make a contract that can reduce the
agency cost. How strong this incentive is is not clear. One approach is to state that
agents are opportunistic and try to transfer wealth from principals because agents
assume that price protection and ex post settling up for dysfunctional behavior are
incomplete. This argument is called 'opportunistic' perspective. This is also called the
ex post approach because it places contracts from the company as given and argues
that the ex post (i.e. after the contract is in place), the agent has an incentive to
transfer wealth from the principal due to contractual terms and renegotiation of
existing contracts it is not possible to truly 'complete' or eliminate the benefits that
can be obtained (i.e. the agent contract is incomplete).
In applying the opportunistic perspective of contract theory to debt contracts
implies that managers will act by trying to transfer wealth from lenders to
shareholders. An alternative to the opportunistic approach is an efficient contracting
approach. If the contract is efficient, then they will align the interests of agents and
principals so that these actions can benefit agents and principals, and can increase
the value of the company. Although recognizing that agents have an incentive to
transfer wealth from principals, the 'efficient contract' approach, or ex ante approach,
to agency theory argues that agents recognize that if they try to transfer wealth from
the principal, they will be penalized for this activity in the future . That is, there will be
a solution which will ultimately eliminate the benefits of opportunistic behavior. The
argument acknowledges that reputation effects will reduce the remuneration paid to
agents in the future if they carry out dysfunctional behavior. Therefore, the agent will
negotiate a contract that is in line with the interests of the principal. This perspective
is called 'efficient' because agency costs are minimized in the long run. That is, the
value of the company, the value of the principal claim, and the value of the
remuneration of the agent will all be greater and more evenly allocated so that
according to the opportunistic perspective this approach is also called ex ante
because agents behave as if the contract has been negotiated to limit their behavior.
F. SIGNALLING THEORY
In addition to the contract perspective, Holthausen describes a further
perspective on the choice of accounting policies. In this perspective, managers
voluntarily provide information to investors to help their decision making. Managers
do this role because they have a comparative advantage in the production and
dissemination of information. Holthausen then proceeded to distinguish the
perspective of the contract and information according to the time of the cash flow
and accounting information. Based on the information perspective, accounting
information predicts cash flow can affect company value. Accounting information is
used to show how the value of the company and claims against it will change. Under
the efficient contract perspective, accounting reflects the changing cash flows that
affect the company: accounting reports are used to monitor events and economic
transactions that occur.

G. POLITICAL PROCESSES
Positive accounting theory also models the political process involving
relationships between companies and other parties interested in companies, such as
government, trade unions and community groups. As in the context of debt and
management compensation contracts, accounting is important in the political
process as a source of information about the company. The main difference between
the political market and the capital market in general is the lack of demand, and
therefore incentives will be smaller, to produce information in the political market.
Economic analysis suggests that this is a result of lower marginal benefits for
individuals in the political process, because it is more difficult for individuals or
groups to benefit from that information. There are high information costs for
individuals, heterogeneity (diversity) interests, and organizational costs.

H. CONSERVATISM, ACCOUNTING STANDARDS AND AGENCY COSTS

In capital markets that function well with shareholders and corporate
democracy, there are appropriate levels of contracts that minimize agency costs.
This assumes dominance (or control) by principals (shareholders and debtholders)
with a slight residual loss. Another approach is more towards the agent control
model with limited power for debtholders and shareholders. This arises because
managers have limited ownership and limited liabilities and this makes a bias in
determining the estimated value.
Traditional conservatism (prudent) in accounting means accelerating
expenditure and delaying recognition of income: '. ... anticipate no profit but
anticipate all losses. ' Conservatism arises because there are asymmetric verification
requirements that impose a higher level of income verification when compared to the
burden and generally function to reduce earnings reports. Furthermore, the valuation
system is based on historical costs, and revaluations (mainly carried on income) are
not permitted in the United States. In addition, the effective use of conservative
historical costs means that any increase in asset value will affect profits as long as
they are generated through transactions, not through direct imposition of value.
Recently, the International Accounting Board (IASB) has argued that
conservative biases in accounting do not reveal the 'real' picture of a company's
finances and reduce the information available to investors. They propose that timely
recognition of both profits and losses is equally important. In response, conditional
conservatism theorists argue that the demand for timely recognition of profits is
lower. This means that the market places a higher value on loss recognition in a
timely manner. The reasons for this are the roles played by external reporting
practices in providing corporate governance externalities by: (a) ex ante -
downplaying trophy investments, and (b) ex post - stopping negative cash flow
investments. Trophy investments occur when management invests in projects that
extend management 7 control or increase prestige. It is not a project that always has
a positive NPV. If management knows that they are required by accounting
standards to reduce the value of this investment in the near future, then they will be
careful in investing.

I. ADDITIONAL EMPIRICAL TESTS OF THE THEORY

Testing The Opportunistic and Political Cost of The Hypotheses ⇒ The effect of
GPLA (general price level adjustment accounting) is to restate the company's
account according to the general inflation index, so that it can increase the value of
assets, but (generally) will decrease reported profit due to higher depreciation costs.
Watts and Zimmerman argue that, due to political factors, managers of large
companies have greater incentives to reduce reported profits. The expected effects
vary with the size of the potential tax relief, rate regulation and bookkeeping costs.
Test Using Contract Details ⇒ The same amount of company transfers with a
maximum profit smaller than the lower limit, or zero. Where there is an upper limit,
the amount transferred will be bound by this limit. Under the profit threshold,
management does not get a bonus. Between the threshold (lower limit) and ceiling
level (upper limit) of profits, management gets a bonus that will increase as long as
the company's profits increase. Above the upper limit, management will get a bonus
with a constant maximum level that does not increase as long as profits increase
above the limit.
Refining The Specification of Political Costs ⇒ Godfrey and Jones investigated
incentives for companies to conduct smooth reporting of operating profits. They
found that managers of companies with highly unionized labor (and therefore subject
to political costs related to labor) sought to influence the probability of wealth
transfers by "smoothing reported net operating profit" by classifying profits and loss
as "extraordinary" or "operating".
Testing The Efficient Contracting Hypothesis
Interest Capitalization ⇒ Zimmer anticipates that ex ante contracts between
companies and customers that 'cost plus' cause interest capitalization to be intended
for two reasons. First, even though capitalization usually increases the manager's
bonus, the management compensation committee will increase the capitalization of
interest and cover revenues through a cost plus contract. Second, implementation
that is consistent in capitalizing interest on specially funded projects will save time in
negotiating with auditors and customer's cost investigators.
Changes In The Chief Executive Officer ⇒ The Dechow and Sloan studies show that
management contracts can balance stock-based and profit-based incentives to
ensure that efforts to transfer wealth from shareholders to managers are largely
ineffective. Thus, accounting and other contract requirements can reduce agency
costs when incentives for opportunism are strong.
Other studies ⇒ corporate economic attributes influence the nature of debt and
management compensation contracts, and that traditional opportunistic contract
variables are related to accounting policy choices.

J. EVALUATING THE THEORY

Methodological and Statistical Criticisms
A major criticism of positive accounting theory is that empirical evidence
relating to an explanation of the choice of accounting policies and the effects on
stock prices and company contracts is still weak and inconclusive. In particular,
methodological and statistical criticism explains that:
● The explanatory variables were insignificant and not of the predicted sign
● Predictive power (R2) of the hypothesised models is low
● there is collinearity among the contracting (explanatory) variables
● the cross-sectional models are poorly specified
● crude measures, such as firm size, to operational political costs are not well
defined in a theoretical sense, nor in a measurement sense (errors in
variables).
Christie tested the hypothesis hypothetically that positive accounting theory
can explain the choice of accounting procedures by combining test results by
published studies. He concluded that there were six general variables for one or
more positive initial accounting research studies that were consistent and statistically
significant, namely: (1) managerial compensation, (2) interest coverage, (3)
leverage, (4) size, (5) dividend constraints, and (6) risk.
Philosophical Criticisms
Tinker, Merino and Neimark suggest that positive accounting theory is
contrary to value-laden claims, because researchers choose the topic to be
investigated and the methods and assumptions that will be applied. Christenson
characterizes positive accounting theory not as accounting theory, but as a sociology
of accounting because it concentrates on human behavior not on the behavior of
accounting entities. A number of papers have given the view that the methodology of
positive accounting theory is not with the purpose intended to serve. In concentrating
on criticizing the original papers of Watts and Zimmerman, critics have ignored the
increase in evidence supporting the basic hypothesis of positive accounting theory.

K.ISSUES FOR AUDITORS

Auditors have a bonding and monitoring role in agency theory. Auditing is now
a legal requirement but there is evidence that auditing was voluntarily undertaken in
the past. Research has also shown that higher quality auditors are demanded in
situations where clients wish to signal that their accounts are of higher quality or
where there are severe agency conflicts or weak control mechanisms. Industry
specialist auditors are able to demand higher audit fees, and clients demand
research and development contract specialist auditors when firms have highly
discretionary expenditures on research and development growth options.