Course : F0812 Accounting Theory

Year
: February 2011

Positive Theory of Accounting Policy and

Disclosure
Session 10

GODFREY
HODGSON
HOLMES
TARCA

CHAPTER 11
POSITIVE THEORY OF
ACCOUNTING POLICY AND
DISCLOSURE

Early demand for theory

Capital markets research tried to explain
the effects of accounting
was ultimately inconclusive and inconsistent
mechanistic and no-effects hypotheses

This research relied upon the EMH

ultimately there were too many departures

Led to the development of a positive

theory of accounting policy choice

Early demand for theory

Positive theory incorporated a number
of observations
many firms voluntarily provided
accounting reports
firms lobbied in relation to accounting
standards
firms made consistent policy choices
firms tended toward conservatism

Contracting theory
The firm is seen as a nexus of
contractual relationships
The firm is seen as an efficient way
of organising economic activity to
reduce contracting costs
equity (management) contracts (an
agency contract)
debt contracts (an agency contract)
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Agency theory
An agency contract is one where one party
(the principal) engages another (the agent) to
act on their behalf
e.g. where there is a separation of management
and ownership

Both parties are utility maximisers

agent may therefore act from self-interest
divergence of interests is the agency problem
contracts incorporating accounting numbers can
be used to align the interests of both parties
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Agency theory
The agency problem in turn gives
rise to agency costs spent to
overcome it
monitoring costs
bonding costs
residual loss

Agency theory

Monitoring Costs the cost of monitoring

the agents behaviour; initially borne by the
principal but passed on to the agent through
an adjustment to their remuneration (price
protection)

auditing costs, operating rules

Bonding Costs the cost borne by the agent

as a result of them taking action to align their
interests with those of the principal

providing more regular financial reports (a cost

to the manager in terms of time and effort)
constraints on their activities
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Agency theory
The agents incur bonding costs in
order to reduce the monitoring costs
they eventually bear
Agents stop spending on bonding
costs when the marginal cost equals
the marginal reduction in the
monitoring costs they bear
$1 = $1
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Agency theory
Residual Loss the loss associated with
not being able to fully align the interests of
the agent with those of the principal
Ex post settling up (ex post = at the
end of each period)
agents future remuneration based on
observed agent performance
the principal changes the remuneration to be
paid to the agent to align it with their
performance
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Agency theory
In the real world, price protection and
settling up are not perfect or complete
Agents perceive that they will therefore not
be fully penalised for their divergent
behaviour
They have incentives to act opportunistically
This increases the residual loss
This loss is borne by the principal as well as,
or instead of, the agent
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Agency theory
Agency theory attributes a role for
accounting
Accounting is part of the monitoring
and bonding mechanisms
Accounting numbers are used in
contracts

13

Price protection and

shareholder/manager agency
problems
The separation of ownership and
management leads to divergent
behaviour by agents
Divergence comes about because of
the risk-aversion problem
the dividend-retention problem
the horizon problem

14

Price protection and

shareholder/manager agency
problems
Risk aversion
managers prefer less risk than do
shareholders
different degrees of diversification affecting
risk
limited liability accorded to shareholders

15

Price protection and

shareholder/manager agency
problems
Dividend-retention
managers prefer to pay out less of the
profits as dividends than shareholders
prefer
pay their remuneration
empire building

16

Price protection and

shareholder/manager agency
problems
Horizon
managers have a shorter time horizon
with respect to their association with the
firm than do shareholders
shareholders are interested in future cash
flows
managers have a time horizon only as long
as they intend to remain with the firm

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Price protection and

shareholder/manager agency
problems
Contracting can be used to reduce
the severity of these problems
manager remuneration is usually tied to firm
performance in some way to motivate
managers to act in the shareholders interest
performance can be related to accounting numbers
such as sales, profits, return on assets, net asset
growth, cash flow, etc
performance can be related to the firms share price

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Shareholder-debtholder
agency problems
In this context, the manager is
assumed to be either the sole owner
of the firm, or has interests that are
totally aligned with the interests of
the shareholders
the principal is the debtholder
the agent is the manager acting on
behalf of shareholders
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Shareholder-debtholder
agency problems
Firm value is the value of debt plus
the value of equity
The value of equity can be increased
by
either increasing the value of the firm
(efficient contracting); or
transferring wealth away from
debtholders (opportunistic behaviour)
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Shareholder-debtholder
agency problems
Varieties of opportunistic behaviour
excessive dividend payments
asset substitution
underinvestment
claim dilution

21

Shareholder-debtholder
agency problems
Excessive dividend payments
reduces the asset base securing the debt
shareholders have received cash but limited
liability protects them from being personally
liable for the debts of the firm in the event of
bankruptcy
the debt becomes mispriced
reduces the value of the debt

22

Shareholder-debtholder
agency problems
Asset substitution
firm invests in higher risk projects to
benefit shareholders
no benefit to debtholders
but do share in possible losses

shareholders are able to diversify and

have limited liability
debt becomes mispriced

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Shareholder-debtholder
agency problems
Underinvestment
in some circumstances, shareholders
have incentives not to undertake
positive NPV projects because to do so
would increase the funds available to
the debtholders but not to the
shareholders

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Shareholder-debtholder
agency problems
Claim dilution
occurs when the firm issues debt of a
higher priority than the debt already on
issue
decreases the relative security and
value of the existing debt

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Shareholder-debtholder
agency problems
Lenders will price protect
through interest rates, the withholding
of funds and the length of the loan

The interests of shareholders can be

bonded to those of debtholders via
restrictions in lending agreements
loan covenants

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Ex post opportunism
versus ex
ante efficient
Ex post opportunism
contracting

occurs when, once a contact is in place,

agents take actions that transfer wealth
from principals to themselves

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Ex post opportunism
versus ex
ante efficient
Ex ante efficient contracting
contracting

occurs when agents take actions that

maximise the amount of wealth
available to distribute between
principals and agents
ex ante before contracts are finalised

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Signalling theory
Managers voluntarily provide
information to investors - signals - to
assist in their decision making
Similar to efficient contracting
Aligned with the information hypothesis
Managers signal expectations and
intentions regarding the future
Incentives to signal good, neutral and
bad news
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Political processes
Often firms try to avoid public
attention that is costly to them
financially
in terms of public perception and
reputation

They reduce their reported profit or

its volatility
e.g. banking sector in Australia
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Conservatism,
accounting standards and
Conservatism
agency
costs shows a bias by

accountants accelerating recognition

of expenses and decelerating
recognition of revenue
IASB argues this does not reveal the
real financial picture and reduces
information available to users

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Additional empirical tests

of the theory
Testing the opportunistic and political
cost hypothesis
Tests using contract details
Refining the specification of political
costs
Testing the efficient contracting
hypothesis
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Additional empirical tests

of the theory
Evidence that managers use
accounting numbers to
counter political pressure
gain political advantages
set management targets related to
remuneration
minimise breaching debt covenants
provide dividend constraints
constrain management manipulation
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Evaluating the theory

Mixed support for positive accounting
theory
Two categories of major criticism
methodological and statistical criticism
empirical evidence is weak and inconclusive

philosophical criticism
contrary to its claims, it is laden with value
judgments
focuses on human behaviour and not the behaviour
and measurement of accounting entities
positivism is no longer taken seriously
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Issues for auditors

The demand for auditing can be
explained by agency theory as part
of the monitoring and bonding
activity and costs
higher quality auditors
industry specialist auditors

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Summary
Positive accounting theory has been a major
force in academic accounting research
Incorporates a theoretical model of
contractual exchange between persons who
use accounting numbers to effect their payoffs
Provides an explanation as to why accountants
account as they do
minimises the cost of agency relationships
yet opportunistic behaviour by agents is the norm
but some efficient ex ante behaviour by agents
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Key terms and concepts

Positive theory
Contracting theory
Agency theory
Agents
Principals
Monitoring costs
Bonding costs
Residual loss
Ex post settling up
Risk aversion problem
Dividend retention problem
Horizon problem
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Key terms and concepts

Shareholder/manager agency problem

Shareholder/debtholder agency problem
Excessive dividend payment problem
Asset substitution problem
Underinvestment problem
Claim dilution problem
Ex post opportunism
Ex ante efficient contracting
Signalling theory
Political processes
Conservatism

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