Positive theory of accounting - policy and disclosure

LECTURE 11

POSITIVE THEORY OF ACCOUNTING POLICY AND

DISCLOSURE

ARTHIK DAVIANTI, SE. MSI. AK. CA.

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

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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

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EARLY DEMAND FOR THEORY

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 behalfe.g. where there is a separation of management and ownership

Both parties are utility maximisersagent 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

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AGENCY THEORY

• Monitoring Costs – the cost of monitoring the agent’s 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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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) agent’s 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

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AGENCY THEORY

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

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Risk aversionmanagers prefer less risk than do shareholders different degrees of diversification

affecting risk limited liability accorded to shareholders

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AGENCY PROBLEMS

Dividend-retentionmanagers prefer to pay out less of the profits as dividends than shareholders prefer pay their remuneration empire building

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AGENCY PROBLEMS

Horizonmanagers 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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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 firm’s share price

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AGENCY PROBLEMS

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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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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Varieties of opportunistic behaviour excessive dividend payments asset substitution underinvestment claim dilution

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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

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Asset substitution:1. firm invests in higher risk projects to

benefit shareholders no benefit to debtholders but do share in possible losses

2. shareholders are able to diversify and have limited liability

3. debt becomes mispriced

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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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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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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

CONTRACTING

Ex post opportunism occurs when, once a contact is in place,

agents take actions that transfer wealth from principals to themselves

Ex ante efficient contracting occurs when agents take actions that

maximise the amount of wealth available to distribute between principals and agents

ex ante – before contracts are finalised25

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 AGENCY COSTS

Conservatism 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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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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ADDITIONAL EMPIRICAL TESTS OF THE THEORY

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 31

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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SOURCE:GODFREY, HODGSON, HOLMES, AND TARCA

(2012) ACCOUNTING THEORY 7 TH EDITION

IAI (2015) STANDAR AKUNTANSI KEUANGANPER EFEKTIV 1 JANUARI 2015

Business

Positive theory of accounting - policy and disclosure