Deegan 5 Ech

Chapter 3
Theories of financial
accounting
Copyright 2007 McGraw-Hill Australia Pty Ltd
3-1
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
3-2
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)
3-3
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
3-4

(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
3-5

(cont.)
Agency costs
Monitoring costs
Bonding expenditures
Residual loss
3-6

(cont.)
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
3-7

(cont.)
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
3-8

(cont.)
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
3-9

(cont.)
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
3-10

(cont.)
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
3-11

(cont.)
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
3-12

(cont.)
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
3-13

(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)
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
3-14

(cont.)
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 firms performance so also
common to find the use of share-based reward
structures, which in certain circumstances, might be
deemed to be more efficient
3-15

(cont.)
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
3-16

(cont.)
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
3-17

(cont.)
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
3-18

(cont.)
Other mechanisms that align the interests of managers
and owners
Threat of takeovers to underperforming firms
A well-informed labour market
3-19

(cont.)
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
3-20

(cont.)
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
3-21

(cont.)
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
3-22

(cont.)
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
3-23

(cont.)
Ways to reduce political costs
Management might:
adopt income-reducing accounting techniques
make voluntary social disclosures
3-24
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
firms 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.
3-25
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
3-26
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)
3-27
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
3-28
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
3-29
Normative accounting theories

Seek to provide guidance in selecting accounting
procedures that are most appropriate
Prescribe what should be done
3-30
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
3-31

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
3-32

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)
3-33

Exit-price accounting
Continuously Contemporary Accounting
Uses exit or selling prices to value the entitys 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
3-34

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 assets current replacement cost
3-35
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
3-36
Systems-oriented theories (cont.)

Stakeholder Theory
Two branches
1. Ethical (normative) branch
2. Managerial (positive) branch
Ethical (normative) branch
stakeholders are any group or individual who can affect or are

affected by the achievement of the firms 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
3-37

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 timeassociated
with control of resources
the firm will take actions to manage its relationships with
stakeholders
3-38

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
3-39

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
3-40

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
3-41

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
3-42
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
3-43
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
3-44

introduced (cont.)
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
3-45

introduced (cont.)
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
3-46

introduced (cont.)
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
3-47
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 markets 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)
3-48
Summary (cont.)
Normative theories of accounting
prescribe how accounting should be practised
argue typically that a central role of accounting theory is
to provide prescriptioninform 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
3-49
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 pressureshow a firm operates and what it
reports must be determined upon consideration of various
stakeholder expectations
3-50
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
theoryhowever, different theoretical perspectives can at
various times provide valuable insights in accounting
issues
3-51

Deegan 5 Ech

Hochgeladen von

Dokumentinformationen

Originaltitel

Copyright

Verfügbare Formate

Dieses Dokument teilen

Dokument teilen oder einbetten

Freigabeoptionen

Stufen Sie dieses Dokument als nützlich ein?

Sind diese Inhalte unangemessen?

Copyright:

Verfügbare Formate

Deegan 5 Ech

Hochgeladen von

Copyright:

Verfügbare Formate

Chapter 3

Copyright 2007 McGraw-Hill Australia Pty Ltd

Copyright 2007 McGraw-Hill Australia Pty Ltd

Positive Accounting Theory (PAT)

Copyright 2007 McGraw-Hill Australia Pty Ltd

Positive Accounting Theory (PAT)

Copyright 2007 McGraw-Hill Australia Pty Ltd

Positive Accounting Theory (PAT)

Copyright 2007 McGraw-Hill Australia Pty Ltd

Positive Accounting Theory (PAT)

Copyright 2007 McGraw-Hill Australia Pty Ltd

Positive Accounting Theory (PAT)

Copyright 2007 McGraw-Hill Australia Pty Ltd

Positive Accounting Theory (PAT)

referred to as ex ante perspective

Copyright 2007 McGraw-Hill Australia Pty Ltd

Positive Accounting Theory (PAT)

assumes managers will opportunistically select accounting

Copyright 2007 McGraw-Hill Australia Pty Ltd

Positive Accounting Theory (PAT)

Managers have access to information not available

Copyright 2007 McGraw-Hill Australia Pty Ltd

Positive Accounting Theory (PAT)

Copyright 2007 McGraw-Hill Australia Pty Ltd

Positive Accounting Theory (PAT)

May also be rewarded based on market price of

Positive Accounting Theory (PAT)

Copyright 2007 McGraw-Hill Australia Pty Ltd

Positive Accounting Theory (PAT)

Positive Accounting Theory (PAT)

Copyright 2007 McGraw-Hill Australia Pty Ltd

Positive Accounting Theory (PAT)

Copyright 2007 McGraw-Hill Australia Pty Ltd

Positive Accounting Theory (PAT)

Copyright 2007 McGraw-Hill Australia Pty Ltd

Positive Accounting Theory (PAT)

Copyright 2007 McGraw-Hill Australia Pty Ltd

Positive Accounting Theory (PAT)

When discussing the agency costs of debt it is

Copyright 2007 McGraw-Hill Australia Pty Ltd

Positive Accounting Theory (PAT)

Copyright 2007 McGraw-Hill Australia Pty Ltd

Positive Accounting Theory (PAT)

Organisations are affected by governments, trade unions,

Copyright 2007 McGraw-Hill Australia Pty Ltd

Positive Accounting Theory (PAT)

Political costs (cont.)

Accounting numbers might be used as a means of

Copyright 2007 McGraw-Hill Australia Pty Ltd

Positive Accounting Theory (PAT)

Copyright 2007 McGraw-Hill Australia Pty Ltd

Discussion leads to 3 main hypotheses of

Copyright 2007 McGraw-Hill Australia Pty Ltd

Selection of accounting methods can be explained by either

Copyright 2007 McGraw-Hill Australia Pty Ltd

Accounting policy selection

Copyright 2007 McGraw-Hill Australia Pty Ltd

Accounting policy selection

Copyright 2007 McGraw-Hill Australia Pty Ltd

Does not provide prescription so does not provide a means of

Copyright 2007 McGraw-Hill Australia Pty Ltd

Normative accounting theories

Copyright 2007 McGraw-Hill Australia Pty Ltd