Chapter 2
Application of accounting
theory
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STATUTORY LICENCES
Slides 6, 8, 12, 19, 22, 23 & 24: Questions created by Dr YH Tham, Unit
Coordinator for Financial Accounting, School of Accounting at Curtin
University; answers reproduced (from original slides) with permission of
Wiley.
The remaining slides are reproduced with permission of Wiley; all images
reproduced with permission of Shutterstock.
Learning objectives
After studying this presentation, you should be able to:
2.1
Describe the role of professional judgement in the preparation of
financial reports
2.2
Identify the major decision areas in considering policies to account
for transactions and other events
2.3
Explain how normative and positive theories are used in accounting
2.4
Explain the implications of positive accounting theory for accounting
policy choice
2.5
Compare the implications of the mechanistic hypothesis and the
efficient market hypothesis for financial reporting
Professional judgement in accounting
• Accounting is not only a set of accounting rules or
procedures.
• Accountants exercise professional judgement.
• Theories help us to:
– predict accounting policy choice
– understand the implications of alternative
accounting policies
– provide a source of guidance in accounting policy
decisions
What is an accounting policy?
There are four components that an accounting policy
needs to address. Can you name them?
Click here to reveal answer
Accounting policy decisions need to address the
following components:
•
•
•
•
Definition
Recognition
Measurement
Disclosure
Applies to both a one-off transaction or routine
transactions.
What is accounting theory?
Theory
– The coherent set of hypothetical, conceptual and
pragmatic principles forming a general framework
of reference for a field of enquiry.
What is an accounting theory?
What are the two available types of accounting
theory?
Click here to reveal answer
Types of theories:
• Normative theories: Prescribe what should happen.
• Positive theories: Explain or predict activities.
Positive accounting theory
• ‘Designed to explain and predict which firms will and
which firms will not use a particular method’ (Watts
& Zimmerman, 1986, p.7)
• Attempts to explain accounting policy decisions by
examining a range of relationships or contracts
• Derived from the nexus of contracts view of the firm
and agency theory
Positive accounting theory
Nexus of contracts:
– Organisation is characterised as a ‘nexus of
contracts’ or as the centre of contractual
relationships, with the contracting parties.
– Theory focuses on three relationships:
• Managerial contracts
• Debt contracts
• Political contracts
Positive accounting theory
Agency theory:
– understand relationships whereby a person, or
group of persons (the principal), employs the
services of another (the agent) to perform some
activity on their behalf
Agency theory
What is an agency relationship?
Click here to reveal answer
Agency relationship:
• A principal delegates decision-making authority to
an agent.
• The agent has a legal and fiduciary duty to act in the
best interests of the principal.
• But managers are likely to act in their own interests,
based on the assumption that all parties are utility
maximisers.
Positive accounting theory
Agency costs
– Monitoring costs:
• To observe, evaluate and control the agent’s
behaviour.
– Bonding costs:
• To provide assurance that they are acting in the
principal’s best interests.
Positive accounting theory
Agency costs
– Residual loss:
• The loss in value of the entity that results from
the separation of ownership of control, when
the marginal cost exceeds the expected benefit
of additional monitoring and bonding.
Positive accounting theory
Owner-manager agency relationships:
– Smith and Watts (1982) identify three major
problems in owner-manager agency relationships:
• Horizon problem: differing time horizons are
important to each party
• Risk aversion: managers generally prefer less
risk
• Dividend retention: managers’ preference to
hold onto funds
Positive accounting theory
Owner-manager agency relationships:
– Remuneration contracts can help to align the
interests of managers with those of owners
– Accounting information can be used in such
contracts to specify performance targets, monitor
actual performance and determine the amount of
rewards, such as a bonus, that the managers will
receive
Positive accounting theory
Manager-lender agency relationships:
– When a lender agrees to provide funds to an
entity, there is a risk that the borrower may not
honour its obligation to repay all of the borrowed
funds with interest.
– Financial statements are then used to monitor
compliance with debt covenants.
Positive accounting theory
Manager-lender agency relationships:
– Smith and Warner (1979) identify problems that
increase the lenders risk:
• Excessive dividend payments to owners
• Asset substitution
• Claim dilution
• Underinvestment
Manager – lender agency relationship
What is a debt covenant and why is it used in a
lending agreement?
Click here to reveal answer
Manager-lender agency relationships
• Debt contracts with covenants based on accounting
numbers, such as maximum leverage ratio, can help
to reduce agency problems of debt and enable the
lender to take action, such as demand repayment, if
debt covenants are breached.
• Financial statements are then used to monitor
compliance with debt covenants.
Positive accounting theory
Political relationships:
– Entities have political relationships:
• Governments
• Trade unions
• NGOs
– Political contracts are typically implicit in nature
– Lobbying and other forms of political action are
costly and therefore more likely to be targeted
against larger, more profitable companies
Positive accounting theory
Role of accounting information in reducing agencyproblems:
– Plays several related roles in the contracting
process
– Is a source of information about the entity in
political processes
– Used to monitor performance
– Can give rise to incentives for accounting policy
Positive Accounting Theory
What are the implications of agency theory for
accounting policy choice?
Click here to reveal answer
Implications of agency theory for accounting policy choice:
• Bonus plan hypothesis: Managers with bonus plans prefer
accounting policies that increase profit. Managers, acting in
their own interest, prefer more remuneration.
• Debt hypothesis: Managers of entities with high leverage
prefer accounting policies that increase profit and equity.
• Political cost hypothesis: Managers of larger entities are
more likely to prefer accounting policies that reduce profit.
The role of accounting in
capital markets
What are the two different hypothesis of accounting
in capital markets?
Click here to reveal answer
The mechanistic hypothesis:
• Predicts that the securities market reacts
mechanistically to changes in accounting numbers.
• Investors are assumed to ignore differences in
accounting policies.
• Implication that investors could be fooled by cosmetic
changes in accounting policies.
The efficient markets hypothesis:
• It is a proposition that markets are efficient.
• In an efficient market:
o Security prices make a rapid and unbiased
adjustment to new information
o So price fully reflects available information.
The role of accounting in
capital markets
What are the 3 forms of market efficiency?
Click here to reveal answer
The efficient markets hypothesis:
• The three forms of market efficiency vary in terms
of the information set.
• Reflected in security prices:
o Weak: the security price reflects
information contained in the sequence of
past prices.
o Semi-strong: the security price reflects all
publicly available information.
o Strong: the security price reflects all
privately and publicly available
information.
The role of accounting in capital markets
What does accounting theory tell us about accounting
policies?
– Capital markets theories attempt to explain the
effects of accounting policy choice on share prices
– The mechanistic hypothesis predicts that
investors ignore differences in accounting policy
choice and fixate on reported numbers
The role of accounting in capital markets
What does accounting theory tell us about accounting
policies?
– The semi-strong form of the efficient market
hypothesis predicts that the share price will
rapidly impound all publicly available
information including the choice of accounting
policy on accounting numbers
Summary
• Professional judgement in the preparation of financial reports
• Major decision areas in considering policies to account for transactions
and other events
• Normative and positive theories in accounting
• Implications of positive accounting theory for accounting policy choice
• Implications of the mechanistic hypothesis and the efficient market
hypothesis for financial reporting