Chapter 3

. Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 3-1

Chapter 3Theories of financial

accounting


Objectives of this lecture• 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


Why do we bother discussing theories when we are studying financial accounting?• We believe that not only is it useful to discuss the

requirements of the various accounting standards—as we will do in depth in the following weeks—but that it is important to provide frameworks—as we do in this lecture—within which to consider the implications of organisations making particular accounting disclosures, whether voluntarily or as a result of a particular mandate

• We also think it is useful to consider the various pressures, many of which are political in nature, that influence the accounting standard-setting environment

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Why do we bother discussing theories when we are studying financial accounting? (cont.)• Because the impact of financial accounting resonates

throughout society it is important to understand the possible implications of an organisation making particular disclosures

• Theories also provide us with the basis for understanding the various pressures that drive organisations to make particular disclosures, even in the absence of disclosure requirements pertaining to particular transactions and events

• By covering the material in this lecture, students will gain a greater understanding of the implications of various accounting standards and other disclosure requirements (the development of thinking accountants!)

Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 3-4


Theory definition—what is a theory?• A coherent group of propositions or principles

forming a general framework of reference for a field of inquiry

• Accounting theories—and there are many—often explain and predict accounting practice (referred to as positive theories) or prescribe particular practice (referred to as normative theories)


Positive Accounting Theory (PAT)• The first theory we shall describe is Positive

Accounting Theory (popularised by Watts and Zimmerman)

• Positive Accounting Theory is 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

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Positive Accounting Theory (PAT) (cont.)• PAT 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



Positive Accounting Theory (PAT) (cont.)PAT accounting theory was developed, in part, from another theory known as agency theory. Agency theory discusses agency relationships, problems and costs.•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


Positive Accounting Theory (PAT) (cont.)Agency costs• Monitoring costs• Bonding expenditures• Residual loss


Positive Accounting Theory (PAT) (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


Positive Accounting Theory (PAT) (cont.)PAT predictions• To try to improve efficiency, organisations will seek

to put in place mechanisms to align the interests of managers of the firm (the agents) with the interests of the owners (principals)

• Some of these mechanisms rely on the output of the accounting system– For example, owners might agree to pay a manager a

bonus based on a specified percentage of profits


Positive Accounting Theory (PAT) (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

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Positive Accounting Theory (PAT) (cont.)• Efficiency perspective of PAT (cont.)

– 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—it 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



Positive Accounting Theory (PAT) (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 (i.e., 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


Positive Accounting Theory (PAT) (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


Positive Accounting Theory (PAT) (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


Positive Accounting Theory (PAT) (cont.)Bonus schemes• Remuneration based on the output of the

accounting system• Very common to find accounting-based

remuneration structures 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


Positive Accounting Theory (PAT) (cont.)Accounting-based bonus schemes• Any changes in the accounting methods used by an

organisation will affect the bonuses paid (e.g. as a result of a new accounting standard)

• Changing the bonuses paid impacts on cash flows, and this in turn is predicted to impact on the value of the organisation

• Contracts may rely on ‘floating’, generally accepted accounting principles


Positive Accounting Theory (PAT) (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 firm’s performance—so also common to find the use of share-based reward structures, which in certain circumstances might be deemed to be more efficient


Positive Accounting Theory (PAT) (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


Positive Accounting Theory (PAT) (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


Positive Accounting Theory (PAT) (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


Positive Accounting Theory (PAT) (cont.)

Other mechanisms that align the interests of managers and owners •Threat of takeovers to underperforming firms•A well-informed labour market



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


Positive Accounting Theory (PAT) (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



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


Positive Accounting Theory (PAT) (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

• There will be a perception that highly profitable organisations can ‘afford’ to pay higher salaries, higher taxes, reduce prices—so if firms reduce ‘profits’ such expectations might decrease


Positive Accounting Theory (PAT) (cont.)Ways to reduce political costs• Management might:

– adopt income-reducing accounting techniques– make voluntary social disclosures


Discussion leads to three main hypotheses of PAT that attempt to explain or predict accounting practice

• 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 firm’s debt/equity ratio, the more likely managers will be to use accounting methods that increase income

• The political cost hypothesis predicts that large firms (that are assumed to be subject to high levels of political scrutiny), rather than small firms, are more likely to make accounting choices that reduce reported profits

• So, in considering the usefulness of PAT, how might auditors utilise the above hypotheses/predictions when undertaking a financial statement audit?


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


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)

– PAT provides potential insights into why managers might elect to select or change accounting policies


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 • PAT provides one perspective on why creative

accounting might occur (of course, there could be other perspectives)

• It is possible to be creative and still follow accounting standards


Criticisms of PAT• Does not provide prescription so does not provide a

means of improving accounting practice• Not value-free but rather is value-laden• Underlying assumption of wealth maximisation is

simplistic• Issues being addressed have not shown any

significant development• Scientifically flawed


Normative accounting theoriesIn contrast with positive theories, normative theories:•seek to provide guidance in selecting accounting procedures that are most appropriate•prescribe what should be done


Normative accounting theories ( cont.)The Conceptual Framework:• is considered a normative theory• seeks to identify the objective of General-Purpose

Financial Reporting• 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


Normative accounting theories ( cont.)Other normative theories• Three main classifications

1. Current-cost accounting2. Exit-price accounting3. Deprival-value accounting

• These theories addressed issues associated with changing prices

• Developed in 1950s and 1960s during a period of high inflation


Normative accounting theories ( cont.)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)


Normative accounting theories ( cont.)Exit-price accounting• Continuously Contemporary Accounting• Uses exit or selling prices to value the entity’s 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


Normative accounting theories ( cont.)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 asset’s current replacement cost


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


The organisation viewed as part of a wider social system


Systems-oriented theories (cont.)Stakeholder TheoryTwo branches

1. Ethical (normative) branch2. Managerial (positive) branch

1. 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

– All stakeholders have a right to be provided with information


Systems-oriented theories (cont.)Stakeholder Theory (cont.)1. Ethical (normative) branch (cont.)– Because it prescribes how stakeholders should be treated

(based on various ethical perspectives), it is a normative approach and is based on various ethical perspectives

2. 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 time—

associated with control of resources– The firm will take actions to ‘manage’ its relationships with

stakeholders


Systems-oriented theories (cont.)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

2. Managerial branch (cont.)– 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– From this perspective, if a stakeholder group does not have

power then their information demands might not be met


Systems-oriented theories (cont.)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


Systems-oriented theories (cont.)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• Research using this theory (and a number of studies

are referred to in the textbook) shows that when the legitimacy of an organisation is threatened (perhaps as a result of a particular incident or event) managers will use information disclosure to try to maintain or regain legitimacy


Systems-oriented theories (cont.)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

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Systems-oriented theories (cont.)Institutional Theory (cont.)• Isomorphism

– coercive– mimetic– normative

• Decoupling– Actual practices can be very different from formally

sanctioned and publicly pronounced processes and practices



Theories explaining why regulation is introduced• Just as there are theories to explain why particular

accounting disclosures are made (e.g. PAT, Legitimacy Theory, Stakeholder Theory), or why particular organisational forms exist (Institutional Theory), there are also theories to explain why particular regulations (e.g. accounting regulations) are developed. Such theories include:– Public interest theory– Capture theory– Economic interest group theory


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 and not motivated by self-interest


Theories explaining why regulation is introduced (cont.)Capture theory• While regulations might initially be introduced in the

‘public interest’, the regulated parties will seek ultimately to take charge of (or capture) the regulator

• They will seek to ensure that rules subsequently released are advantageous to themselves (the parties subject to the regulation)


Theories explaining why regulation is 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• If regulators believe that particular regulation will provide

economic benefits to themselves (the regulators) then they will support that regulation


Theories explaining why regulation is introduced (cont.)Economic interest group theory (cont.)• The regulator is not a neutral arbiter but is seen as an interest

group• The 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


Summary• The lecture 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 market’s 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)


Summary (cont.)Normative theories of accounting

– Prescribe how accounting should be practised– Argue typically that a central role of accounting theory is to

provide prescription—inform 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


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 pressures—how a firm operates and what it reports must be determined upon consideration of various stakeholder expectations


Summary (cont.)Theories that seek to explain how regulation is developed•Some theories (public interest theory) 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’ theory—however, different theoretical perspectives can at various times provide valuable insights in accounting issues

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Chapter 3