C HAP TER 3 Theories of financial accounting Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. LEARNING OBJECTIVES (LO) 3.1 Understand what constitutes a ‘theory’, appreciate why students of financial accounting should know about various theories, and understand the difference between normative and positive theories. 3.2 Understand the central tenets of Positive Accounting Theory and in doing so understand what constitutes an ‘agency relationship’ and be aware of the major aspects of ‘agency theory’. 3.3 Understand that, pursuant to Positive Accounting Theory, the choice of alternative accounting methods can often be explained from either an ‘efficiency perspective’ or an ‘opportunistic perspective’. 3.4 Understand that, from a Positive Accounting Theory perspective, accounting-based measures are often used to resolve conflicts between managers and owners. 3.5 Understand that, from a Positive Accounting Theory perspective, accounting-based measures are often used to resolve conflicts between managers and debtholders. 3.6 Understand the meaning of ‘political costs’ and how the choice of particular accounting methods might be used as a strategy to reduce political costs. 3.7 Understand what is meant by ‘creative accounting’ and why it might occur. 3.8 Understand the basis of the various criticisms of Positive Accounting Theory. 3.9 Be aware of some normative theories of accounting, such as current-cost accounting, exit-price accounting and deprival-value accounting. 3.10 Know what a ‘systems-based theory’ is and why a systems-based theory would be relevant to the study of accounting. 3.11 Understand the basic tenets of Stakeholder Theory and its applicability to explaining accounting practice. 3.12 Understand the basic tenets of Legitimacy Theory and its applicability to explaining accounting practice. 3.13 Understand the basic tenets of Institutional Theory and its applicability to explaining accounting practice. 3.14 Understand that there are theories which explain why regulation—such as accounting regulation—is introduced and understand the basic tenets of Public Interest Theory, Capture Theory and the Economic Interest Group Theory of regulation. Before reading this chapter, watch the accompanying video of Craig Deegan explaining why this topic is important for your studies. Deegan, C. (2019). Financial100 accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 100 10/24/19 12:47 PM Chapter 3: Theories of financial accounting 101 OPENING QUESTIONS Before reading this chapter, please consider how you would answer the following five questions. We will return to these questions at the end of the chapter, where we suggest some answers. 1. Can the practice of financial reporting be undertaken without knowledge of various theories that can be related to accounting? LO 3.1 2. Can the implications of various aspects of financial reporting be well understood in the absence of knowledge of related theories? LO 3.1 3. What is the difference between a positive theory and a normative theory? LO 3.1 4. Is the IASB Conceptual Framework for Financial Reporting a normative or positive theory of accounting? Why? LO 3.9 5. Identify three theories that could be used to explain why particular regulation, such as specific regulation pertaining to financial reporting, has been enacted. LO 3.14 AASB STANDARDS REFERRED TO IN THIS CHAPTER AND IFRS/IAS EQUIVALENTS AASB no. 15 Title IFRS/IAS equivalent Revenue from Contracts with Customers 101 Presentation of Financial Statements IAS 1 102 Inventories IAS 2 108 Accounting Policies, Changes in Accounting Estimates and Errors IAS 8 138 Intangible Assets IAS 38 1023 General Insurance Contracts 3.1 Introduction to theories applicable to financial accounting Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. IFRS 15 — LO 3.1 In the previous two chapters we discussed the bodies responsible for regulating general purpose financial reporting within Australia. We also discussed the IASB Conceptual Framework for Financial Reporting. As will be demonstrated in this chapter, a conceptual framework can be described as a normative theory of accounting. It prescribes, within a particular framework, the objectives and the qualitative characteristics that financial information should possess if it is to fulfil the objectives (as defined within the Conceptual Framework) of general purpose financial reporting. In this chapter we explore some of the many theories—in addition to conceptual frameworks—that can relate to financial accounting. We will see that different theories often have different objectives and can adopt different assumptions about what motivates human behaviour. For example, we will discuss theories that seek to: ∙ explain and predict which accounting methods or approaches management is likely to select when it has alternatives from which to choose (these theories are commonly referred to as positive theories) ∙ explain and predict which stakeholders will be (or perhaps, should be) the intended audience for the reports being released by organisational managers ∙ prescribe which accounting methods should be used in particular circumstances (these theories are commonly referred to as normative theories, the Conceptual Framework being an example of a normative theory) ∙ explain how or why accounting regulation is developed (with some theories arguing that accounting regulation is developed in the ‘public interest’ and other economics-based theories promoting the view that accounting regulation is introduced to serve the interests of some parties over and above the interests of others). The theory overview in this chapter will provide readers with knowledge of some of the various theories that have been developed and that can relate to the practice of accounting. For more detailed coverage, refer to specialised texts devoted entirely to accounting theory, a number of which are listed under ‘Further reading’ at the end of the chapter. In this chapter, we will demonstrate that in the decade or so leading up to the 1970s the notable accounting theories being developed were predominantly normative in nature; that is, they identified what accounting techniques and methods should be applied by reporting entities. Reflecting the higher inflation rates of the time, most of these Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 101 10/24/19 12:47 PM 102 PART 2: Theories of accounting normative theories were concerned with providing guidelines on how to account for assets and expenses in times of rising prices. The attention of many accounting researchers continues to focus on the development of normative theories of accounting, such as the Conceptual Framework. However, in the 1970s a number of accounting researchers developed a theory of accounting known as Positive Accounting Theory, which seeks to explain and predict the selection of particular accounting policies and their impact, rather than prescribing what should be done. Positive Accounting Theory therefore has a different emphasis and purpose from normative accounting theories. After reading this chapter, you will realise that, among accounting researchers, there is a great deal of disagreement on the role of accounting and of accounting theory; for example, some people argue that theory should explain practice, while others argue it should direct, improve or guide practice (and some people think it should do both). These contrasting types of theories have generated considerable debate within the accounting literature, and this debate is ongoing. Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. Why discuss theories in a book such as this? The study of financial accounting and reporting can be approached in a number of different ways. One approach adopted in many financial accounting textbooks is for the authors to provide an explanation of the rules incorporated within particular financial accounting standards and then illustrate how to apply these rules. That is, a number of texts are predominantly procedural in nature, failing to reflect any deeper thinking about the impact or appropriateness of particular accounting standards and other pronouncements. For example, many financial accounting textbooks elect not to discuss how readers of financial statements might react to the disclosures required by the standards; whether newly mandated disclosures will have positive or negative effects on the organisation; how particular stakeholders affect the disclosure decisions of organisations; and how particular accounting disclosures will influence an organisation’s relationships with other parties within society. Other financial accounting texts have introduced a chapter on theory (often driven by a competitive desire to show they have such a chapter) but then subsequently fail to integrate the discussion of theory with the practical material pertaining to accounting standards that follows. In contrast with such texts, the author of this book believes that not only is it useful to discuss the requirements of the various accounting standards—as we do in depth in the following chapters—but that it is important to provide theoretical frameworks—as we do in this chapter—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. Of course, the balance of the material in this book could be studied without reading this chapter. However, because the impact of financial accounting resonates throughout society—that is, accounting is both a technical and a social practice—we believe this chapter provides readers with the necessary background to understand the possible implications of an organisation making particular disclosures. The theories in this chapter also provide the basis for understanding the various pressures or incentives that drive managers to use particular accounting methods, or to make particular disclosures, even in the absence of disclosure requirements pertaining to particular transactions and events. By reading this chapter, together with the material in other chapters of this book, we believe that readers will gain a greater understanding of the broader implications of various accounting standards and other reporting requirements. Definition of ‘theory’ Before we consider some theories, it might be useful to discuss what we mean by a theory. There is no one definitive meaning of the term ‘theory’. The Macquarie Dictionary provides a useful Coherent set of definition: ‘a coherent group of propositions used as principles of explanation for a class of hypothetical, conceptual and pragmatic principles phenomena’. forming the frame of The accounting researcher Hendriksen (1970, p. 1) defines a theory as ‘a coherent set of reference for a field of hypothetical, conceptual and pragmatic principles forming the general framework of reference for inquiry. a field of inquiry’. Hendriksen’s definition is very similar to the US Financial Accounting Standards Board’s definition of its Conceptual Framework Project, discussed in Chapter 2: ‘a coherent system of interrelated objectives and fundamentals that is expected to lead to consistent standards’. It is generally accepted that a ‘theory’ is much more than simply an idea, or a ‘hunch’, which is how the term is used in some contexts (for instance, we often hear people say that they have a ‘theory’ about why something might have occurred when they mean they simply have a ‘hunch’). theory Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 102 10/24/19 12:47 PM Chapter 3: Theories of financial accounting 103 Theories applicable to accounting typically either explain and/or predict accounting practice, or they prescribe specific accounting practice. As indicated above, such theories are typically referred to as positive and normative theories respectively. According to Henderson, Peirson & Brown (1992, p. 326): A positive theory begins with some assumption(s) and, through logical deduction, enables some prediction(s) to be made about the way things will be. If the prediction is sufficiently accurate when tested against observations of reality, then the story is regarded as having provided an explanation of why things are as they are. For example, in climatology, a positive theory of rainfall may yield a prediction that, if certain conditions are met, then heavy rainfall will be observed. In economics, a positive theory of prices may yield a prediction that, if certain conditions are met, then rapidly rising prices will be observed. Similarly, a positive theory of accounting may yield a prediction that, if certain conditions are met, then particular accounting practices will be observed. Because positive theories seek to explain and predict particular phenomena, they are often developed and supported on the basis of observations (that is, they are empirically based). The view is that by making numerous observations we will be better placed to predict what will happen in the future (for example, we might study many managers within a particular industry to predict what accounting methods they will select in particular circumstances). By contrast, normative theories are sometimes referred to as prescriptive theories, because they seek to inform others about particular practices that should be followed to achieve particular outcomes. For example, a normative accounting theory might, given certain key assumptions about the nature and objective of accounting, prescribe how assets should be measured for financial statement purposes, or a normative theory might prescribe that particular stakeholders should receive particular accounting-based information. The prescriptions about what should be done might represent significant departures from current accounting practice (for example, for many years Raymond Chambers promoted a theory of accounting that prescribed that assets should be measured at market value—at a time when entities were predominantly using historical cost). Therefore, it is not appropriate to assess the validity, or otherwise, of a normative theory on the basis of whether entities are actually using one method or another, although this is a common method of evaluating or testing a positive theory. A normative theory might prescribe a radical departure from current practice. The dichotomy of positive and normative accounting theory provides a useful basis for the following discussion. Worked Example 3.1 explores the main differences between a positive and normative theory. Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. WORKED EXAMPLE 3.1: The differences between a positive theory and a normative theory REQUIRED What are the main differences between a positive theory and a normative theory? SOLUTION A positive theory is a theory that, based upon various assumptions, explains and/or predicts particular events, for example, the choice by a manager to disclose particular information. The ‘worth’ of a positive theory is typically assessed on the basis of empirical observation—that is, whether the predictions of the theory are subsequently consistent with the available evidence. By contrast, a normative theory is a theory that prescribes particular actions, for example, that managers should disclose particular information to certain stakeholders. The prescriptions will be based upon the beliefs or values of the researcher and might represent significant departures from current practice. WHY DO I NEED TO KNOW ABOUT SOME THEORIES THAT PERTAIN TO THE PRACTICE OF FINANCIAL REPORTING? Theories allow us to ‘make sense’ of the world in which we live by providing a framework (or a logical basis) to explain what might be occurring at a point in time, or what actions should be implemented at a particular time to achieve particular desired outcomes. As students of accounting, we arguably need to understand such issues as why managers might select particular approaches to accounting when they have choices available, or why they should select particular accounting methods, as well as understand some possible implications that might flow from the reporting decisions made by managers, or the regulatory decisions made by accounting standard-setters. Theories can provide such insights. Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 103 10/24/19 12:47 PM 104 PART 2: Theories of accounting 3.2 Positive Accounting Theory LO 3.2 The first theory we will consider is Positive Accounting Theory. The name Positive Accounting Theory (PAT) can in itself cause confusion. As we now know, a positive theory is a theory that explains and predicts a particular phenomenon. Positive Accounting Theory (PAT) seeks to explain and predict accounting Positive Accounting practice. It does not seek to prescribe particular actions. Watts and Zimmerman (1986, p. 7) state: Theory (PAT) [PAT] is concerned with explaining [accounting] practice. It is designed to explain and predict which firms will and which firms will not use a particular [accounting] method . . . but it says nothing as to which method a firm should use. Theory that seeks to explain and predict accounting practice. According to Watts (1995, p. 334), the use of the term ‘positive research’ was popularised in economics by Friedman (1953) and was used to distinguish research that sought to explain and predict from research that aimed to provide prescription. Positive Accounting Theory, the theory that was popularised by Watts and Zimmerman, is one of several positive theories of accounting. Legitimacy Theory, Institutional Theory and Stakeholder Theory, all discussed in this chapter, are other examples of positive theories. These other positive theories are not grounded in classical economics theory, as is the case with Positive Accounting Theory. We can refer to the general class of theories that attempts to explain and predict accounting practice in lower-case letters (that is, as positive theories of accounting), and we can refer to Watts and Zimmerman’s particular positive theory of accounting as Positive Accounting Theory (that is, with initial letters in upper case). Hence, while it might be confusing, we must remember that Watts and Zimmerman’s Positive Accounting Theory is one specific example of a positive theory of accounting. This confusion might not have arisen had Watts and Zimmerman elected to adopt a different name (or ‘trademark’) for their particular theory. According to Watts and Zimmerman (1990, p. 148): Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. We adopted the label ‘positive’ from economics where it was used to distinguish research aimed at explanation and prediction from research whose objective was prescription. Given the connotation already attached to the term in economics we thought it would be useful in distinguishing accounting research aimed at understanding accounting from research directed at generating prescriptions . . . The phrase ‘positive’ created a trademark and like all trademarks it conveys information. ‘Coke’, ‘Kodak’, ‘Levis’ convey information. Normative accounting theorists have criticised PAT because it does not provide practitioners with guidance, even though it does attempt to explain the possible economic implications of selecting particular accounting policies. PAT focuses on the relationships between certain classes of stakeholders involved in providing resources to an organisation. This could be the relationship between the owners (as suppliers of equity capital) and the managers (as suppliers of managerial labour), or between the managers and the firm’s debt providers. Many relationships involve the delegation of decision making from one party (the principal) to another agency relationship party (the agent): this is referred to as an agency relationship. Involving the delegation of decision making from the The delegation of decision-making authority can lead to a loss of efficiency and, consequently, principal to an agent. increased costs. For example, if the owner (the principal) delegates decision-making authority to a manager (the agent), it is possible that the manager will not work as hard as the owner would, given that the manager does not share directly in the results of the organisation. Any loss of profits brought about because the manager underperforms is considered to be a cost of decision-making delegation within this agency relationship—an agency cost. The agency costs that arise as a result of delegating decision-making authority from the owner to the manager are referred to in PAT as agency costs of equity. PAT investigates how particular contractual arrangements, many based on accounting numbers, can be put in place to minimise agency costs. One of the most frequently cited expositions of PAT is provided in Watts and Zimmerman (1978). In developing PAT, Watts and Zimmerman relied heavily upon the work of a number of other authors, notably Jensen and Meckling (1976) and Gordon (1964). PAT, developed by Watts and Zimmerman and others, is based significantly on particular assumptions and methods used in the economics literature and, in particular, on the central assumptions of economics that all individual action is driven by self-interest and that individuals will act in an opportunistic manner to increase their wealth. This arguably is not a very ‘favourable’ perspective of humankind, but it is perhaps consistent with the damage we see caused to the environment, and to various societies, by large organisations in their pursuit of profits and greater personal wealth. Notions of loyalty and morality are not incorporated within PAT (nor in many other accounting theories). Organisations are considered collections of self-interested individuals who have agreed to cooperate. Such cooperation does not mean that they have abandoned self-interest as an objective; rather it means only that they have entered into contracts that provide sufficient incentives to gain their cooperation. Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 104 10/24/19 12:47 PM Chapter 3: Theories of financial accounting 105 Given the assumption (again, borrowed from economics literature) that self-interest drives individual actions— an assumption that is disdained by many accounting researchers, and particularly those with concerns about social and environmental sustainability, as will be indicated later in this chapter—PAT predicts that organisations will seek to put in place mechanisms that align the interests of the managers of the firm (the agents) with the interests of the owners of the firm (the principals). As we will see, some of these methods of aligning interests will be based on the output of the accounting system, such as providing the manager with a share of the organisation’s profits. Hence the theory’s direct application to explaining particular accounting practices. Where such accounting-based alignment mechanisms are in place, financial statements will need to be produced. Managers are required to bond themselves to prepare these financial statements. This is costly in itself and under PAT would be referred to as a bonding cost. If we assume that managers (agents) will be responsible for preparing the financial statements, PAT would also predict that there would be a demand for those financial statements to be audited or monitoring cost Cost incurred monitoring monitored. Otherwise, assuming self-interest, agents would attempt to overstate profits, thereby the performance of others. increasing their absolute share of profits. In PAT, the cost of undertaking an audit is referred to as a monitoring cost. Various bonding and monitoring costs might be incurred to address the agency problems that arise within an organisation. If it was assumed, contrary to the assumption of ‘self-interest’ employed by PAT, that individuals always worked for the benefit of their employer, there would be less demand for such activities—other than, perhaps, to review the efficiency with which managers operate businesses. As PAT assumes that not all the opportunistic actions of agents can be controlled by contractual arrangements or otherwise, there will always be some residual costs associated with appointing an agent (known as residual loss). Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. 3.3 Efficiency and opportunistic perspectives of PAT LO 3.3 Research that applies PAT typically adopts either an efficiency perspective or an opportunistic perspective. From the efficiency perspective, researchers explain how various contracting mechanisms can be put in place to minimise the agency costs of the firm—that is the costs associated with assigning decision-making processes to an agent. The efficiency perspective is often referred to as an ex ante perspective—ex ante meaning ‘before the fact’— as it considers what mechanisms are introduced up front with the objective of minimising future agency costs. For example, many organisations throughout the world voluntarily prepared publicly available financial statements before regulation compelled them to do so. These financial statements were also frequently subject to audit even though there was no statutory requirement to do so (Morris 1984). Researchers such as Jensen and Meckling (1976) argue that the practice of providing audited financial statements leads to real cost savings as it enables organisations to attract funds at lower costs (in other words, it is an efficient use of the organisation’s resources to prepare financial statements and have them audited). As a result of the audit, external parties have more reliable information about the resources of the organisation, which is thus perceived to be able to attract funds at a lower cost than would otherwise be possible. This is because, in the absence of information, it would be difficult to assess the ongoing ‘health’ of an investment in an entity, and this inability to monitor performance would increase the risk associated with an investment. With higher risk, the entity’s cost of attracting capital would increase. Providing ‘credible’ information will arguably lead to a decrease in risk, and a consequent decrease in the costs of attracting capital to the entity. Within the efficiency (ex ante) perspective of PAT, it is also argued that the accounting practices adopted by firms are often explained on the basis that such methods best reflect the underlying financial performance of the entity. Different organisational characteristics are used to explain why different firms adopt different accounting methods. For example, the selection of a particular asset depreciation rule from among many alternative approaches is explained by the fact that it best reflects the underlying use of the asset. Firms that have different patterns of use in relation to an asset are predicted to adopt different amortisation policies. By providing measures of performance that best reflect the underlying performance of the firm, it is argued that investors and other parties will not need to gather as much additional information from other sources. This will lead to cost savings. As an illustration of research that adopts an efficiency perspective, Whittred (1987) sought to explain why firms voluntarily prepared publicly available consolidated financial statements in a period when there was no regulation requiring them to do so. (Consolidated financial statements are constructed by aggregating the financial statements of numerous organisations within a group of entities where the group comprises a parent entity and its controlled entities.) Whittred found that when companies borrowed funds, security for repayment of the debt often took the form of guarantees provided by entities within the group of organisations. Consolidated financial statements were described as being a more efficient means of providing information about the group’s ability to borrow and repay debts than providing lenders with separate financial statements for each entity within the group. Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 105 10/24/19 12:47 PM Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. 106 PART 2: Theories of accounting If it is assumed, consistent with the efficiency perspective, that firms adopt particular accounting methods because they best reflect the underlying performance of the entity, then it is often argued by PAT theorists that the regulation of financial accounting imposes unwarranted costs on reporting entities. For example, if a new accounting standard is released that bans an accounting method being used by a particular organisation, then this could lead to inefficiencies as the resulting financial statements will no longer provide the best reflection of the performance of the organisation. This in itself is believed likely to lead to an increase in the firm’s costs, because if an organisation is no longer able to provide information that best reflects its financial position and performance, this increases the risks of investors and debt providers, who consequently will demand a higher rate of return. Many PAT theorists would argue that management is best able to select which accounting methods are appropriate in given circumstances, and government should not intervene in the process (an anti-regulation argument). Such theorists oppose a ‘one-size-fits-all’ approach to accounting regulation, in which particular accounting standards are required to be used by all reporting entities even though the nature of their operations, financial structure and products might be greatly different. The opportunistic perspective of PAT, on the other hand, takes as given the negotiated contractual arrangements of the firm and seeks to explain and predict certain opportunistic behaviours that will subsequently occur. The opportunistic perspective is often referred to as an ex post perspective—ex post meaning ‘after the fact’—because it considers opportunistic actions that could be taken—typically by managers—once various contractual arrangements have been put in place. For example, in an endeavour to minimise agency costs (an efficiency perspective), a contractual arrangement might be negotiated that provides managers with a bonus based on the profits generated by the entity (for example, a manager might be given a bonus that is 5 per cent of reported profits). This will act to align the interests of the managers with the interests of the owners as both parties would likely prosper from increasing profits. Once the contractual arrangement is in place, however, the manager could opportunistically elect to adopt particular accounting methods that increase accounting profits and therefore the size of any bonus (an opportunistic perspective). For example, managers might elect to adopt a particular depreciation method that increases profits even though it might not reflect the actual use of the asset (this can be referred to as an example of ‘earnings management’). It is assumed within PAT that managers will opportunistically select particular accounting methods whenever they believe this will lead to an increase in their personal wealth (remember, PAT embraces the rather pessimistic assumption that all individuals are driven by self-interest). PAT assumes that principals (or owners) would predict a manager will be opportunistic. With this in mind principals often stipulate the accounting methods to be used for particular purposes. For example, a bonus plan agreement might stipulate that a particular depreciation method such as straight-line depreciation must be adopted to calculate income for the determination of a bonus. However, it is assumed to be too costly to stipulate in advance all accounting rules to be used in all circumstances. Hence, PAT proposes that there will always be scope for agents to opportunistically select particular accounting methods in preference to others. The following discussion addresses some of the various contractual arrangements that might exist between owners and managers, and between debtholders and managers, particularly contracts that are based on the output of the accounting system. Again, these contractual arrangements are assumed initially to be put in place to reduce the agency costs of the firm (the efficiency perspective). However, it is assumed by Positive Accounting theorists that once the arrangements are in place, parties will adopt manipulative strategies to generate the greatest economic benefits for themselves (the opportunistic perspective). LO 3.4 3.4 Owner–manager contracting A manager who also owns a firm (an owner–manager) bears the costs associated with their own perquisite consumption, which could include consumption of the firm’s resources for private purposes—acquiring an overly expensive company car or luxurious offices or staying in overly expensive hotel accommodation—or the excessive generation and use of idle time. As the percentage of ownership held by the manager decreases, managers begin to bear less of the cost of their own perquisite consumption. The costs begin to be absorbed by the other owners of the firm. As noted previously, PAT adopts as a central assumption that all action taken by an individual is driven by self-interest, and that the major interest of all individuals is to maximise their own wealth. Such an assumption is often referred to as the rational economic person assumption. If all individuals are assumed to act in their own interests, owners would expect managers (their agents) to undertake activities that might not always be in the interests of the owners (the principals). Further, because of their position within the firm, managers will have access to information that perquisite consumption Consumption by employees of non-salary benefits. rational economic person assumption Assumption that all actions by individuals are driven by self-interest, the prime interest being to maximise personal wealth. Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 106 10/24/19 12:47 PM Chapter 3: Theories of financial accounting 107 is not available to principals—a problem frequently referred to as information asymmetry—thus information increasing the potential for managers to take actions that are beneficial to themselves at the expense asymmetry of the owners. The costs of divergent behaviour that arises as a result of the agency relationship— Situation where some individuals have access to that is the relationship between the principal and the agent appointed to perform duties on behalf of certain information that is the principal—are, as indicated previously, referred to as agency costs (Jensen & Meckling 1976). not available to others. It is assumed under PAT that principals expect their agents to undertake activities that might be advantageous to the agents but disadvantageous to the value of the firm (the opportunistic perspective). That is, principals assume that agents will be driven by self-interest. As a result, principals will price this into the amounts they are prepared to pay managers. That is, in the absence of controls to reduce the ability of managers to act opportunistically, principals expect such actions and, as a result, will pay their managers a lower salary. This lower salary compensates the principals for, or protects them from, the expected opportunistic behaviour of the agents/managers (often referred to as ‘price protection’). Managers, therefore, bear some of the agency costs of the opportunistic behaviours in which they might or might not engage. If it is expected that managers would derive greater satisfaction from additional salary than from the perquisites that they will be predicted to consume, managers might be better off if they are able to commit or bond themselves contractually to reducing their set of available actions, some of which would not be beneficial to owners. To receive greater remuneration, managers must be able to convince owners that they will work in the interests of owners. Of course, before agreeing to increase the amounts paid to managers, the owners of a firm would need to ensure that any contractual commitments could be monitored for compliance. Managers could potentially be rewarded: Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. ∙ on a fixed basis, that is, given a fixed salary independent of performance ∙ on the basis of the results achieved, or ∙ by way of a combination of the above two methods. If managers are rewarded purely on a fixed basis, then, assuming self-interest—a central tenet of PAT—they will not want to take great risks because they (like the debtholders) will not share in any potential gains. There will also be limited incentives for these managers to adopt strategies that increase the value of the firm because, unlike equity owners whose share of the firm might increase in value, the managers receiving fixed returns will not directly share in any potential gains. Like debtholders, managers with a fixed claim want to protect their fixed income stream. Apart from rejecting risky projects, which might be beneficial to those with equity in the firm, the manager with a fixed income stream is also reluctant to take on optimum levels of debt, as the claims of the debtholders would compete with the manager’s own fixed income claim. Assuming self-interest drives the actions of managers, PAT theorists argue that it can be necessary to put in place remuneration schemes that reward managers in a way that is, at least in part, tied to the performance of the firm. This will be in the interests of managers as they will potentially receive greater rewards and will not have to bear the costs of perceived opportunistic behaviours (which might not have been bonus scheme engaged in anyway). If the performance of the firm improves, the rewards paid to managers increase Where the manager receives a bonus that is correspondingly. Bonus schemes tied to the performance of the firm are put in place to align the tied to the performance of interests of owners and managers. If the firm performs well, both parties will benefit. Almost all the organisation. organisations have some form of accounting-based bonus schemes in place. Bonus schemes generally It is common for managers to be rewarded in terms of: ∙ the profits of the organisation (sometimes after adjustments to exclude some expenses, such as interest and taxes), or on the basis of the profits generated by particular sub-units, or divisions, of an organisation, and/or ∙ on the basis of the sales of the organisation, or sales generated by a component of the organisation, and/ or ∙ on the basis of some measure pertaining to return on assets. That is, it is common to find that managers’ remuneration is based on the output of the accounting system (hence, depending upon the terms of the bonus scheme, a change in profits might directly affect a manager’s personal wealth). It is also common for managers to be rewarded in terms of the market price of the firm’s shares. This might be through holding an equity interest in the firm or perhaps by receiving a cash bonus explicitly tied to movements in the market value of the firm’s securities. Accounting-based bonus plans Given that the amounts paid to managers might be tied directly to accounting numbers—such as profits/sales/assets— any changes in the accounting methods being used by the organisation can affect the bonuses paid. Such changes can Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 107 10/24/19 12:47 PM 108 PART 2: Theories of accounting occur as a result of a new accounting standard being issued. For example, an article in CFO Magazine (April 2014, p. 8, entitled ‘Revenue Accounting Hits Loans, Bonuses’) notes how an accounting standard issued by the IASB—IFRS 15 Revenue from Contracts with Customers (with the Australian equivalent being AASB 15)—affected the timing of when many organisations recognise revenue and this in turn would affect bonuses tied to corporate sales or profits. As another example, consider the consequences if a new rule is issued that requires all research and development expenditure to be written off. (For organisations that apply IFRSs, subject to certain guidelines, development expenditure can be capitalised and subsequently amortised over future periods.) With such a change, profits would decline and the bonuses paid to managers could also change. If it is accepted, consistent with classical finance theory, that the value of the firm is a function of its future cash flows, the value of the organisation might change as cash flows change. Of course, it is possible for the bonus to be based on the ‘old’ accounting rules in place at the time the remuneration contract was negotiated—perhaps through a clause in the management compensation contract—but this will not always be the case. (As indicated previously, it would be too costly to try to stipulate in advance what accounting methods are to be used subsequently for all transactions.) Contracts that rely on generally accepted accounting numbers might rely on ‘floating’ generally accepted accounting principles. This accounting principles means that changing an accounting rule that affects a measure used within a contract negotiated by Body of conventions, the firm might consequently change the value of the firm (through changes in related cash flows). rules and procedures that are generally applied by Positive Accounting Theory would argue that if a change in accounting policy had no impact on the accountants. cash flows of the firm, the management of the firm would be indifferent to the change. Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. Incentives to manipulate accounting numbers There are a number of costs that might arise if incentive schemes are based on accounting output. For example, it is possible that rewarding managers on the basis of accounting profits can induce them to manipulate the related accounting numbers to improve their apparent performance and, importantly, their related rewards—that is, accounting profits might not always provide an unbiased measure of a firm’s performance or value. Healy (1985) provides an illustration of when managers might choose opportunistically to manipulate accounting numbers owing to the presence of accounting-based bonus schemes (that is, they adopt an opportunistic accounting-based perspective). He found that when schemes existed that rewarded managers after a pre-specified level bonus scheme of profit had been reached, managers would adopt accounting methods consistent with maximising Employee remuneration scheme where employees that bonus. In situations where the profits were not expected to reach the minimum level required by receive a bonus tied to the plan, managers appeared to adopt strategies that further reduced profit in that period (frequently accounting numbers. referred to as ‘taking a bath’). This leads to higher profit in subsequent periods when the profits might be above the required threshold. For example, a manager might write off an asset in one period when a bonus was not going to be earned anyway so that there would be nothing further to depreciate in future periods when profit-related bonuses might be paid. In related research, Holthausen, Larcker and Sloan (1995) utilised private data on a firm’s compensation plans to investigate managers’ behaviour in the presence of management compensation plans. Their results confirmed those of Healy (1985), except that no evidence was found to support the view that management will ‘take a bath’ when earnings are below the lower pre-set bound of the earnings requirement. Research has also shown that large asset write-offs (impairment losses) often follow the replacement of chief executive officers, with new CEOs blaming the losses on the past CEOs and taking credit for the improvements in profits that follow. Investment strategies that maximise the present value of the firm’s resources will not necessarily produce uniform periodic cash flows or accounting profits. It is possible that some strategies might generate minimal accounting profits in early years, yet still represent the best alternatives available to the firm. Rewarding managers on the basis of accounting profits (calculated for just one year and, therefore, short term in orientation) might discourage them from adopting such strategies and might encourage them instead to adopt a shortterm, as opposed to a long-term, focus. In Lewellen, Loderer and Martin (1987), it was shown that US managers approaching retirement are less likely to undertake research and development expenditure if their rewards are based on accounting-based performance measures, such as profits. Working within a PAT framework, this is explained on the basis that all research and development has to be written off as incurred in the USA (as has already been mentioned and will be seen in subsequent chapters, this is not the case in countries that have adopted IFRSs). In such circumstances, incurring research and development costs will lead directly to a reduction in profits. Although the research and development expenditure would be expected to lead to benefits in subsequent years, the retiring managers might not be there to share in the gains. The self-interested manager who is rewarded on the basis of accounting profits is predicted not to undertake research and development in the periods close to the point of retirement. This can, of course, be detrimental to the ongoing operations of the business. In such a case, it would be advisable from an efficiency perspective for an organisation that incurs research Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 108 10/24/19 12:47 PM Chapter 3: Theories of financial accounting 109 and development expenditure to take retiring managers off a profit-share bonus scheme or to calculate ‘profits’ for the purpose of the plan after adjusting for research and development expenditures. Alternatively, managers approaching retirement could be rewarded in terms of market-based schemes, as addressed below. What we are emphasising here is that particular accounting rules can create real social consequences. For example, as a result of the accounting requirements that research and development expenditure is required to be treated as an expense, some managers— particularly those on accounting-based bonuses—might decide not to undertake such research and development and this can have subsequent implications for society (perhaps some miracle cure was about to be found). Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. Market-based bonus schemes Firms involved in some industries might have accounting earnings/profits that fluctuate greatly. Successful strategies might be put in place that will not provide accounting earnings for a number net present value of periods. In such industries, Positive Accounting theorists might argue that it is more appropriate The difference between and efficient to reward managers in terms of the market value of the firm’s securities, which are the present value of the assumed to be influenced by expectations about the net present value of expected future cash future cash inflows and the present value of the future flows. This can be done either by basing a cash bonus on any increases in share prices or by cash outflows relating to a providing managers with shares or options to shares in the firm. If the value of the firm’s shares particular project or object. increases, both managers and owners will benefit and, importantly, managers will be given an incentive to increase the value of the firm. As with accounting-based bonus schemes, there are problems associated with managers being rewarded in terms of share price movements. First, the share price will not only be affected by factors that are controlled by the manager but also by outside, market-wide factors; that is, share prices might provide a ‘noisy’ measure of management performance—‘noisy’ in the sense that they are affected not only by the actions of management but also largely by general market movements over which the manager has no control. Further, only senior managers would be likely to have a significant effect on the cash flows of the firm and, hence, on the value of the firm’s securities. Therefore, market-related incentives might be appropriate for senior management only. Offering shares to lowerlevel management might be demotivating, as their own individual actions would have little likelihood, relative to the actions of senior management, of affecting share prices and, therefore, their personal wealth. Consistent with this, it is more common for senior managers to hold shares in their employer than for other employees. Even at the senior level of management, however, firm-specific events might occur that reduce share prices, even though the manager has no ability to influence the events. As a rather extreme example of how news of events beyond the control of the manager can impact an organisation’s share price, there have been instances where it has been wrongly reported within the news media that well-known senior executives have died (when they had not) and this has caused share prices to sharply fall. In general, it is argued that the likelihood of accounting-based or market-based performance measures or reward schemes being employed will be driven, in part, by considerations of the relative ‘noise’ of market-based versus accounting-based performance measures. The relative reliance upon accounting-based or market-based measures might potentially be determined on the basis of the relative sensitivity of either measure to general market factors, which are largely uncontrollable. Sloan (1993) indicates that chief executive officer (CEO) salary and bonus compensation appears to be relatively more aligned with accounting profits in those firms where: ∙ share returns are relatively more sensitive to general market movements (relatively noisy) ∙ profits have a high association with firm-specific movement in the firm’s share values ∙ profits have a less positive (or more negative) association with market-wide movements in equity values. Accounting-based rewards have the advantage that the accounting results may be based on subunit or divisional performance. However, it needs to be ensured that individuals do not focus on their division at the expense of the organisation as a whole. Positive Accounting Theory assumes that if a manager is rewarded on the basis of accounting numbers—for example, on the basis of a share of profits—the manager will have an incentive to manipulate the accounting numbers in an effort to increase his or her own personal wealth. Given this assumption, the value of audited financial statements becomes apparent. Rewarding managers in terms of accounting numbers—a strategy aimed at aligning the interests of owners and managers—might not be appropriate if management is solely responsible for compiling those numbers. The auditor will act to arbitrate on the reasonableness of the accounting methods adopted. However, it must be remembered that there will always be scope for opportunism. As emphasised earlier, it would be too expensive and, for practical purposes, impossible to pre-specify a complete set of accounting methods to cover all circumstances. In this regard, it should be remembered that the existing accounting standards do not cover all types of transactions and events, and hence there is much latitude for discretion when compiling financial statements. Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 109 10/24/19 12:47 PM 110 PART 2: Theories of accounting The above discussion indicates that incentive-based remuneration contracts might act to motivate managers to take actions that are in the best interests of the owners (that is, to align the interests of managers and owners). Another mechanism, which might complement the employment of efficiently designed management remuneration plans and which might motivate managers, is the threat that an underperforming company might be the subject of takeover attempts. The consequence of this is that underperforming managers/agents might lose their jobs when alternative teams of managers target firms with resources that are currently being used inefficiently by the incumbent management team. Given the assumption of an efficient capital market—another central tenet of PAT—managers might be motivated to use their resources efficiently both for the benefit of the owners and because inefficient utilisation might result in the firm being taken over and subsequently in loss of employment for managers. A well-informed labour market will motivate management to work to maximise the value of its firm. Underperformance might lead to dismissal and, if the labour market is efficient in disseminating data, a ‘failed’ manager might have difficulty attracting a position with comparable pay elsewhere. Positive Accounting Theory also assumes that labour markets are efficient. None of the mechanisms mentioned—private contracting, capital markets and labour market forces—is deemed to be perfectly efficient. However, it is assumed within PAT that the concurrent existence of well-designed management compensation contracts, the market for corporate takeovers, and a well-informed labour market should ensure that management, on average, will act in the best interests of owners. Worked Example 3.2 provides an example of how we can apply PAT to explain a particular phenomenon—in this case the introduction of a bonus plan. WORKED EXAMPLE 3.2: Understanding aspects of managerial bonus plans by applying PAT Quad Fin Company has a bonus plan that rewards the general manager by providing her with a bonus equal to 5 per cent of reported profits. REQUIRED (a) Briefly explain using the efficiency perspective of Positive Accounting Theory why the bonus plan was put in place. (b) Briefly explain using the opportunistic perspective of Positive Accounting Theory whether the general manager could be motivated to try to inflate reported profits. Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. SOLUTION (a) Positive Accounting Theory would suggest that the bonus plan was put in place to encourage the general manager—through an economic incentive—to work hard to maximise the profits of the organisation, and therefore also maximise the economic interests of the owners of the organisation. Higher profits are assumed to be in the interests of the owners. The bonus plan would be seen as a mechanism to efficiently align the (self) interests of the owners, and the managers. (b) Once the bonus plan is in place, to the extent that the general manager can ‘get away with it’, it would be assumed that she will opportunistically attempt to manipulate the reported profits in order to generate the greatest economic benefit to herself. LO 3.5 3.5 Debt contracting When a party lends funds to another organisation, the recipient of the funds might undertake activities that reduce or even eliminate the probability of the funds being repaid. The costs that relate to the divergent behaviour of the borrower are referred to in PAT as the agency costs of debt. For example, the recipient of the funds might pay excessive dividends to owners (shareholders), leaving few assets in the organisation to service or repay the debt. Alternatively, the organisation might take on additional and perhaps excessive levels of debt. The new debtholders would then compete with the original debtholders for repayment. Smith and Warner (1979) refer to this practice as ‘claim dilution’. Further, the borrowing firm might also invest in very high-risk projects. This strategy would not be beneficial to its debtholders. They have a fixed claim and therefore if such a project generates high profits they will receive no Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 110 10/24/19 12:47 PM Chapter 3: Theories of financial accounting 111 greater return, unlike the owners who will share in the increased value of the firm. If such a project fails, which is more likely with a risky project, the debtholders might receive nothing. Therefore, while the debtholders do not share in any profits (the ‘upside’) they do suffer the consequences of any significant losses (the ‘downside’). In the absence of safeguards that protect their interests, debtholders will assume that management will take actions that might not always be in the debtholders’ interest. As a result, in the absence of contractual safeguards, it is assumed that they will require the firm to pay higher costs of interest to compensate for the high-risk exposure (Smith & Warner 1979). If a firm contractually agrees—from an efficiency perspective—that it will not pay excessive dividends, not take on high levels of debt and not invest in projects of an excessively risky nature, it is assumed that the firm will be able to attract debt capital at a lower cost than would otherwise be possible. To the extent that the benefits of lower interest costs exceed the costs that might be associated with restricting how management can use available funds, management will elect to sign agreements that restrict its subsequent actions. Early evidence on debt contracts (negotiated between the providers of debt capital and the managers of the organisation) is provided by Whittred and Zimmer (1986, p. 22). They find that: with few exceptions, trust deeds for public debt place restrictions on the amount of both total and secured liabilities that may exist. The constraints were most commonly defined relative to total tangible assets; less often relative to shareholders’ funds. The most frequently observed constraints were those limiting total and secured liabilities to some fraction of total tangible assets. The above quotation makes reference to ‘public’ debt issues. When we note that something is a ‘public issue’, it means that the particular security (such as a bond/debenture, unsecured note or convertible note) was made available for the public to invest in (with the terms of the issue typically provided within a publicly available prospectus document). Investors in a public debt issue would have a trustee who is to act in the interests of all the public investors. By contrast, a private debt issue involves an agreement between a limited number of parties (perhaps just the organisation and one other party, such as a bank) to provide debt capital to an organisation. Cotter (1998a, p. 187) provides more recent (than Whittred and Zimmer) Australian evidence about debt contracts used in private debt issues. She finds that: Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. Leverage covenants are frequently used in bank loan contracts, with leverage most frequently measured as the ratio of total liabilities to total tangible assets. In addition, prior charges covenants that restrict the amount of secured debt owed to other lenders are typically included in the term loan agreements of larger firms, and are defined as a percentage of total tangible assets. Where covenants restrict the total level of debt that may be issued, this is assumed to lead to a reduction in the risk to existing debtholders. This is further assumed to translate to lower interest rates being charged by the ‘protected’ debtholders. It is worth noting that in her unpublished PhD thesis, Cotter found that the commonly used definition of assets allowed for assets to be revalued. However, for the purposes of debt restriction, some banks restricted the frequency of revaluations to once every two or three years, while others tended to exclude revaluations undertaken by directors of the firm. These restrictions lessen the ability of firms to loosen debt constraints by revaluing assets. Cotter (1998b) found that, apart from debt-to-assets constraints, interest coverage and current ratio clauses are frequently used in debt agreements. Interest coverage clauses typically require that the ratio of net profit—with interest and tax added back—to interest expense be at least a minimum number of times. In the Cotter study, the number of times interest must be covered ranged from one and a half times to four times. The current ratio clauses reviewed by Cotter required that current assets be between one and two times the size of current liabilities, depending on the size and industry of the borrowing firm. In more recent research, Mather and Peirson (2006) showed that, relative to the earlier samples used by Whittred and Zimmer, more recent public debt issues show a ‘significant reduction in the use of debt to asset constraints, such as covenants restricting the total liabilities/total tangible assets, or total secured liabilities to total tangible assets, with only 28 per cent of the sample of recent contracts including these covenants’ (p. 292). However, Mather and Peirson provide evidence that, while there is a reduction in the use of covenants that restrict the amount of total liabilities relative to assets, there appears to be a greater variety of covenants being used relative to earlier years. Among the other covenants they found in debt contracts are requirements stipulating required minimum interest coverage, minimum dividend coverage, minimum current ratio, and required minimum net worth (and total owners’ equity). Again, as we know, if these minimum accounting-based requirements are not met, the borrower is considered to be in technical default of the debt agreement and the lenders may take action to retrieve their funds. As we should appreciate, the purpose of the various debt covenants is to provide lenders with regular and timely indicators of the possibility of a borrowing entity defaulting on repaying its debts. A violation of a debt covenant signals an increase in the likelihood Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 111 10/24/19 12:47 PM 112 PART 2: Theories of accounting of default. However, it needs to be appreciated that the covenant measures are simply indicators of the chances that an organisation will not repay borrowed funds, and that an organisation simply being in technical default of a covenant is not a perfect indicator that the entity would not have repaid the borrowed funds. When debt contracts are written, and where they utilise accounting numbers, the contract can, as we indicated earlier, rely upon either the accounting rules in place when the contracts were signed (often called ‘frozen GAAP’) or the contract might rely upon the accounting rules in place at each year’s reporting date (referred to as ‘rolling GAAP’ or ‘floating GAAP’). Mather and Peirson found that in all but one of the public debt contracts, rolling (or floating) GAAP was to be used to calculate the specific ratios used within the contracts. The use of rolling GAAP increases the risk to borrowers in the sense that if the IASB (and thereafter national accounting standard-setters, such as the AASB) issues a new accounting standard that changes the treatment of particular assets, liabilities, expenses or income, this has the potential to cause an organisation to be in technical default of a loan agreement. For example, a new accounting standard might be released that requires a previously recognised asset to be fully expensed to the income statement (or the statement of profit or loss and other comprehensive income). This could have obvious implications for debtto-asset constraints, or interest coverage requirements. As another more specific example, we can consider the release of IFRS 15 Revenue from Contracts with Customers (the Australian equivalent being AASB 15) in 2014. For many firms this changed when they recognised revenue, which in turn could have potentially affected accounting-based debt covenants. That is, in the absence of the organisation changing any aspect of its business, a new rule in relation to revenue recognition could create changes in measures used in debt covenants, and create various costs associated with defaulting on debt contracts. This in itself could provide the motivation for organisations to actively lobby accounting standard-setters against a particular draft accounting standard. As Mather and Peirson (2006, p. 294) state: Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. The use of rolling GAAP . . . means that new (or revisions to) accounting standards might cause breaches of covenants not anticipated at the time of contract negotiation. When comparing the use of covenants in public and private debt issues, Mather and Peirson found that the mean number of accounting-based covenants used in the sample of public debt contracts is smaller (mean of 1.5) than the mean number of covenants found in the sample of private debt contracts (mean of 3.5). That is, more restrictions were placed on privately negotiated debt agreements. Similarly, where debt covenants restricted total liabilities to total tangible assets, Mather and Peirson found that ‘the limits imposed in public debt contracts (a mean total liabilities/total tangible assets of 82.2 per cent) appear to be less restrictive than those in private debt contracts (mean limit of 75.2 per cent)’. The fact that private debt contracts are more restrictive than public debt contracts can be explained from an efficiency perspective. When a covenant is violated, an organisation is in technical default of the debt contract. If an organisation is in technical default, it often has the option of negotiating with the debtholders to try to come up with a compromise that does not involve immediate repayment of the debt. However, it is very difficult, and sometimes nearly impossible, to renegotiate a satisfactory outcome in a public debt issue, as there are so many diverse parties involved— some of which might not even be able to be contacted. Hence we would expect to find the covenant restrictions to be less restrictive in public debt contracts than in private debt contracts. As with management compensation contracts, PAT assumes that the existence of debt contracts (which are initially put in place as a mechanism to reduce the agency costs of debt and can be explained from an efficiency perspective) provides management with a subsequent (ex post) incentive to manipulate accounting numbers—an incentive that increases as the accounting-based constraint approaches violation. As Watts (1995, p. 323) states: Early studies of debt contract-motivated choice test whether firms with higher leverage (gearing) are more likely to use earnings-increasing accounting methods to avoid default (leverage hypothesis). The underlying assumptions are that the higher the firm’s leverage the less slack in debt covenants and the more likely the firm is to have changed accounting methods to have avoided default. This change is usually interpreted as opportunistic since technical default generates wealth transfers to creditors but it could also be efficient to the extent that it avoids real default and the deadweight loss associated with bankruptcy. For example, if the firm contractually agreed that the ratio of debt to total tangible assets should be kept below a certain figure (and this is considered to reduce the risk of the debtholders not being repaid), if that figure was likely to be exceeded (constituting a technical default of the loan agreement and thereby potentially requiring the entity to repay the funds immediately) management might have an incentive to either inflate assets (perhaps through an upward asset revaluation) or deflate liabilities. This is consistent with the results reported in Christie (1990) and Watts and Zimmerman (1990). To the extent that such an action was not objective, management would obviously be acting opportunistically and not to the benefit of individuals holding debt claims against the firm. Debt agreements typically require financial statements to be audited. Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 112 10/24/19 12:47 PM Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. Chapter 3: Theories of financial accounting 113 Other research to consider how management might manipulate accounting numbers in the debt covenant presence of debt agreements includes that undertaken by DeFond and Jiambalvo (1994) and Restriction within a trust deed/debt contract Sweeney (1994). Both of these studies investigated the behaviour of managers of firms that were on the operations of a known to have defaulted on accounting-related debt covenants. DeFond and Jiambalvo (1994) borrowing entity. provided evidence that the managers manipulated accounting accruals in the years before and the year after violation of the agreement. Similarly, Sweeney (1994) found that as a firm approaches violation of a debt agreement, managers have a greater propensity to adopt income-increasing strategies (which also act to increase assets) compared with managers in firms that are not approaching technical default of accounting-based debt covenants. Income-increasing accounting strategies include changing key assumptions when calculating pension liabilities, and adopting LIFO cost-flow assumptions for inventory. Sweeney (1994) also showed that managers with an incentive to manipulate accounting earnings might also strategically determine when they will first adopt a new accounting requirement. When new accounting standards are issued, there is typically a transitional period (which could be a number of years) in which organisations can voluntarily opt to implement a new accounting requirement. After the transitional period, the use of the new requirement becomes mandatory. Sweeney showed that organisations which defaulted on their debt agreements tended to adopt profitincreasing requirements early, and deferred the adoption of accounting methods that would lead to a reduction in reported profits. In further related research, Franz, Hassabelnaby and Lobo (2014) report that firms close to violating debt covenants are more likely to manage their earnings in a way that reduces the risk of covenant violation. Debt contracts occasionally restrict the accounting techniques that may be used by the firm, thus requiring adjustments to published accounting numbers. For example, and as stated above, Cotter (1998a) shows that bank loan contracts sometimes do not allow the component related to asset revaluations to be included in the definition of ‘assets’ for the purpose of calculating ratios, such as ‘debt-to-assets’ restrictions. These revaluations are, however, allowed for external reporting purposes. Therefore, loan agreements sometimes require the revaluation component to be removed from the published accounting numbers before the calculation of any restrictive covenants included within the debt contract. Within accounting, management usually has available a number of alternative ways to account for particular items and, thus, to minimise the effects of existing accounting-based restrictions. debtholder Therefore, it might appear optimal for debtholders to stipulate in advance all accounting methods External party with a claim against an organisation for that management must use. However, and as noted previously, it would be too costly and impractical the repayment of funds to write ‘complete’ contracts up front. As a consequence, management will always have some previously advanced. discretionary ability to enable it to loosen the effects of accounting-based restrictions negotiated by debtholders. The role of external auditors, if appointed, would be to arbitrate on the reasonableness of the accounting methods chosen. In relation to auditors, and following on from the discussion so far, there would appear to be a particular demand for financial-statement auditing when: ∙ management is rewarded on the basis of numbers generated by the accounting system ∙ the firm has borrowed funds and accounting-based covenants are in place to protect the investments of debtholders. Consistent with the above, it could also be argued that as the managers’ share of equity in leverage (gearing) the business decreases and as the proportion of debt to total assets increases, there will be a Measure of the amount corresponding increase in the demand for auditing. In this regard, Ettredge et al. (1994) show that of debt issued by an entity. The greater the use organisations that voluntarily elect to have interim financial statements audited tend to have greater of debt the greater the leverage (gearing) and lower management shareholding in the firm. gearing. In summing up our discussion on debt contracting we can see that accounting numbers can have significant implications for the ongoing viability of an organisation. Many organisations borrow funds with the terms of the borrowing being stipulated in contracts that incorporate accounting-based debt covenants. Failure to comply with these negotiated covenants (often referred to as a ‘technical breach’ of a covenant or contract) can, at the extreme, lead to the operations of the organisation being suspended or placed in the hands of a party nominated by the lender, while the lenders seek to gain access to their funds. In this regard we can consider an article that appeared in The Sydney Morning Herald in relation to surfwear company Billabong Ltd entitled ‘Write-down puts Billabong in breach of debt covenant’ (by Collin Kruger, 23 February 2013), which stated: BILLABONG’S path to redemption got tougher on Friday after the surfwear group downgraded earnings guidance and said a $537 million loss for the half-year put it in breach of debt covenants. The breach led its banks to seek a secured charge over most of the business . . . The company said it was in breach of its debt covenants owing to the $567 million worth of write-downs for the half-year. The situation has since been remedied, but at a price. Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 113 10/24/19 12:47 PM 114 PART 2: Theories of accounting Billabong said it had agreed to move ‘as soon as practicable’ to a secured banking arrangement with its financiers ‘whereby the company will grant security over the majority of its assets’. The new chief financial officer, Peter Myers, said talks with the banks had been ‘extremely constructive’. While this material has discussed how accounting-based debt covenants are often negotiated between borrowers and lenders, we could perhaps expect that the level of reliance that lenders place on accounting-based indicators, as a means of protecting the funds advanced to an organisation, will be influenced by the perceived integrity of the accounting systems in place within the borrowing organisation. In this regard Costello and Wittenberg-Moerman (2011) find that if an organisation discloses information about internal control failures within its accounting system, lenders will tend to decrease their reliance on the use of accounting-based covenants. Rather, borrowers who have had instances of poor internal controls tend to encounter higher interest rates and additional security requirements. So, in summarising this discussion, we can understand that many organisations have debt contracts in place that use accounting numbers. The use of particular covenants within debt contracts provides a vehicle for transferring certain rights and decision making from shareholders/managers to creditors/lenders when a company appears to be approaching a situation of financial distress. The covenants thereby provide a mechanism to limit managers’ ability to expropriate the wealth of the creditors/debtholders. Consistent with PAT, this in turn provides incentives to managers (assuming self-interest) to adopt income/asset increasing accounting methods, particularly when they are close to breaching debt covenants. In the discussion that follows, we consider how expectations about the political process can also affect managers’ choice of accounting methods. Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. LO 3.6 3.6 Political costs The term ‘political costs’ is used to refer to the costs that particular groups external to the firm may be able to impose on the firm, such as the costs associated with increased taxes, increased wage political costs claims or product boycotts. Costs that groups external Organisations are affected by a multitude of stakeholders, including governments, trade to the firm might be able to impose on the firm as a unions, environmental lobby groups and consumer groups. Research indicates (Watts & result of political actions. Zimmerman 1978; Wong 1988; Deegan & Hallam 1991) that the demands placed on firms by interest groups might be affected by the accounting results of the firm. For example, if a firm records high profits, this might be used as a justification or an excuse for trade unions to take action to increase their members’ share of the profits in the form of increased wages. Publicity, such as media coverage, is not typically given to the accounting methods used to derive particular accounting numbers. Rather, attention seems to be focused on the final numbers themselves, without regard to how those numbers were determined. In this regard, we can consider how representatives of interest groups or political parties might use profits or other accounting numbers as a justification for particular actions. In this respect, a newspaper article appeared in the Hobart Mercury on 9 March 2013 (entitled ‘Tax on big four hits brick wall’) in which the Australian Greens political party used the size of bank assets (measured in accounting terms) as the basis for proposing the levying of additional taxes on banks. In part, the article stated: The Greens want a levy of 0.2 per cent on all bank assets above $100 billion in return for Federal Government guarantees, which the independent Parliamentary Budget Office has costed as raising $11 billion over the next four years. ‘At a time when there’s pressures on the budget, and the government is looking around for ways of raising revenue, especially in light of the failed mining tax, who can afford to pay it the most?’ Australian Greens’ Mr Bandt said yesterday. ‘If we don’t stand up to the big banks and the big miners, then the Labor Party is going to come after the rest of us, like they have with single parents, and like they are threatening with the forthcoming budget.’ From the above extract we can see how an accounting number—total assets—had been used as the basis of justifying levying the additional tax. While the proposal was rejected by the government, it does show how accounting numbers are used in political debates. In the same article, the banks responded by noting how such a proposed tax would impact many people, including retirees and the ‘working Australian’. Such a response would be aimed at trying to dampen any future calls for additional taxes: The Australian Bankers’ Association warned that if the Greens’ policy was adopted it would effectively amount to a tax on Australians’ retirement savings. Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 114 10/24/19 12:47 PM Chapter 3: Theories of financial accounting 115 The association’s chief executive Steven Munchenberg said the majority of bank profits were paid through dividends to mum and dad shareholders and superannuation funds. ‘Taxing banks’ profits reduces those returns for working Australians saving for their retirement through superannuation accounts and to retirees who are increasingly dependent upon positive business profit growth,’ he said. Government departments can also come under political pressure as a result of reported high profits. That is, government departments can also be subject to political costs. As an example of this, we can consider a story about New Zealand Post (the government department responsible for mail deliveries and other services). In an article entitled ‘40c stamp follows $72.3 m profit’ (by Craig Howie, The Dominion, 28 June 1995), the New Zealand communications minister states that the increasing profits of NZ Post were reaching a level at which they could be considered by the community as being ‘obscene’. Possibly in expectation of a community backlash, NZ Post reduced the price of its stamps following the announcement of its profit results. Perhaps such a price reduction would not have occurred if NZ Post had not recorded such a large accounting profit, which in turn attracted negative media attention. Again, we can see that accounting profits can draw unwanted attention to an organisation. An industry’s high profits might also be used as a basis for action by groups that lobby politically for increased taxes or decreased subsidies on the grounds of the industry’s ability to pay. For example, Watts and Zimmerman (1986) examine the highly publicised claims about US oil companies made by consumers, unions and government within the US in the late 1970s. It was claimed at the time that oil companies were making excessive reported profits and were in effect exploiting the nation. It is considered that such claims could have led to the imposition of additional taxes in the form of ‘excess profits’ taxes. Governments seeking re-election could be motivated to take action against unpopular firms or industries if it were considered that there would be a net increase in electoral support. The following extract from an article by Morgan Mellish and Jason Koutsoukis, entitled ‘MPs have banks in their sights’ (Australian Financial Review, 28 November 2000, p. 3) reports the reaction of one banking executive to this possibility: Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. Commonwealth Bank chief executive Mr David Murray yesterday said he was fearful of politicians increasing the anti-bank rhetoric in an effort to capitalise on community anger towards banks. ‘There are a number of elections in Australia next year and we know the political homework that’s been done in the leadup to those elections includes banking as an issue at every level,’ Mr Murray said. The view that politicians will target unpopular industries to bolster their chances of re-election assumes that the actions of most politicians are motivated by a desire to be re-elected—perhaps not an unrealistic assumption and certainly consistent with the PAT assumption that the actions of all individuals can best be explained in terms of selfinterest. Therefore, it is argued that the reported accounting numbers, such as profits, might result in the imposition of costs on the firm, perhaps through increased taxes, calls for reduced prices or calls for wage increases for workers. Generally speaking, it is argued within PAT that accounting numbers can be used as a means of providing ‘excuses’ for effecting wealth transfers in the political process (Holthausen & Leftwich 1983, p. 83). Politicians can rely on accounting numbers to justify their own particular actions or provide ‘excuses’, given the expectation that it is costly for constituents to ‘unravel’ accounting numbers derived from particular, and perhaps alternative, accounting methods. It would also be costly for constituents to determine the ‘real’ motivations for politicians’ actions, or the economic consequences of those actions. For example, a government might decide to reduce the tariff protection of a particular industry and, in doing so, it could highlight the high profits that have been reported by firms within that industry; that is, it could use the profits as an excuse for the action. Consistent with the work of Downs (1957), individual constituents will not have an incentive to investigate more fully the actual motivations of the government. They have only one vote in the political process and the costs of being fully informed about the government’s actions are assumed to be greater than any subsequent benefits constituents could generate from the knowledge. As already indicated, high profits might also be used by consumer groups to justify a position that prices are too high. For example, consider the difficulties a firm might have justifying a price rise for its goods or services if, at the same time, it is recording high profits. Consistent with Watts and Zimmerman (1978), if a firm believes that it is, or might be, subject to political costs, there might be incentives to adopt income-decreasing accounting methods. In the discussion so far, we examined how representatives of interest groups might use profits as a justification for particular actions. Lower reported profits might reduce the likelihood of demands for increased wages. Hence, if management considers that there might be claims for increased wages in particular years, or the industry might be the target for increased taxes or consumer calls for price decreases, then managers might elect to adopt income-decreasing accounting methods (for example, managers might depreciate assets over fewer years, thereby increasing depreciation expense and reducing profits). In this regard, research in the US by Jones (1991) considered the behaviour of 23 firms Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 115 10/24/19 12:47 PM 116 PART 2: Theories of accounting from five industries that were the subject of investigations into government import relief from 1980 to 1985. These investigations by the International Trade Commission sought to determine whether the domestic firms were under threat from foreign competition. Where this threat is deemed to be unfair, the government can grant relief in terms of devices such as tariff protection. In making its decision, the government relies upon a number of factors, including economic measures such as profits and sales. The results of the study show that, in the year of the investigations, the sample companies chose accounting strategies that led to a decrease in reported profits. Such behaviour was not exhibited in the year before or the year after the government investigation (perhaps indicating that politicians are fairly ‘short-sighted’ when undertaking investigations). In other US-based research, Cahan (1992) undertook an investigation of the accounting methods used by organisations subject to investigation by the US Department of Justice and Federal Trade Commission and found that firms under investigation tended to adopt income-reducing accounting strategies. In more recent research of a related nature, Hao and Nwaeze (2015, p. 195) reviewed accounting-related behaviour of the US pharmaceutical industry at a period when it became the target of public condemnation for rising drug prices and at the same time faced the prospect of new laws to curtail its revenues. Firms were expected to adopt accounting methods that would lower their profits and thus reduce their unpopularity for being highly profitable, thereby also reducing calls from the public for additional legislation. The authors found a variety of accounting actions were indeed employed that reduced reported profits—consistent with a political cost hypothesis. This study represented yet another example of research that sought to confirm the ‘political cost hypothesis’—a hypothesis that has been subject to repeated investigation for approximately 40 years. WHY DO I NEED TO KNOW ABOUT THE INSIGHTS PROVIDED BY PAT? Even though PAT is often criticised because of the very negative perspective it embraces with respect to what motivates people (that is, that people are primarily motivated by wealth-maximising self-interest), it does provide useful insights into how numbers generated by financial reporting are used in contractual arrangements negotiated between various stakeholders, such as between owners, managers and debtholders. It also provides a basis for understanding why ‘creative accounting’ might occur and for understanding why and how financial accounting measures, such as profits, are used by different groups in order to justify certain actions being taken against an organisation. Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. Earnings management We can relate some of the above material from PAT to what is now commonly referred to as ‘earnings management literature’. Where managers and their accountants adopt particular accounting policies, or make particular accountingbased decisions primarily to generate desired measures of profits/earnings, this is often referred to as earnings management. Earnings management can also occur through managers deciding to undertake, or not undertake, certain transactions primarily because of the way those transactions will influence reported profits. Earnings management can be done to influence the perceptions that some stakeholders might have about an organisation, or to impact certain economic outcomes that are linked to financial accounting numbers. According to Schipper (1989), earnings management occurs when managers use the flexibility inherent within accounting standards to manage an organisation’s reported accounting profits in order to influence some economic outcome to the organisation’s benefit. One of the key factors that drives earnings management is the pressure on managers to report sound short-term performance (profits). As indicated above, earnings management can be, and often is, undertaken as a result of making (or deferring) various discretionary accruals of income or expenses (often referred to as ‘accrual-based earnings management’), or it can come about as a result of selectively undertaking actual transactions near the end of the financial year (sometimes referred to as ‘real earnings management’). In this regard, and according to Zang (2012), accrual-based earnings management and real earnings management can both be employed by an organisation depending upon the relative costs and benefits of each type of earnings management, with the costs of accrual-based earnings management increasing with the existence of stronger outside monitoring. In this regard, Anagnostopoulou and Tsekrekos (2017) provide evidence that in the presence of high levels of leverage/debt (or changes in debt), the trade-off between real earnings management and accrual-based earnings management turns into a ‘complementary effect’. This evidence is interpreted as an indication that very high leverage is typically accompanied by strong outside scrutiny, making it necessary for firms to use real earnings management in combination with accrual-based earnings management to be able to achieve particular earnings targets. Such findings are deemed to provide evidence that an environment of Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 116 10/24/19 12:47 PM Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. Chapter 3: Theories of financial accounting 117 increased monitoring and scrutiny supports a preference by managers for real earnings management as opposed to accrual-based earnings management. Various organisation-based factors, including internal governance practices, have been found to affect the incidence and type of earnings management employed by managers. For example, it has been argued that the longer the expected remaining working life of senior managers, the less the likelihood that the managers will focus opportunistically on short-term performance. Conversely, the shorter the remaining expected working life of a senior manager, the greater the likelihood of a manager making decisions that generate profits (and rewards to the manager) in the short term. According to Cheng, Lee and Shevlin (2016), senior managers below the level of CEO—who are expected to have a longer remaining working life, which motivates them to care more about long-term value of the organisation—are expected to be less likely to support activities that sacrifice long-term positive net present value investments to meet short-term earnings targets. Conversely, CEOs would typically have fewer years left in their working life and would be relatively more in favour of earnings management that generates higher short-term performance measures. Further, Cheng et al. (2016) also argue that the more influence that key subordinate executives have, the more effective the internal governance will be, and the less likely it is that the company will engage in activities for the sake of impacting short-term profits. However, this ability to reduce the propensity of an organisation to engage in transactions aimed at increasing short-term profits will be reduced the greater the power and authority of the CEO within the organisation. Cheng et al. (2016) also argue that firms that are about to issue debt or equity will benefit more from beating earnings benchmarks or targets as this can increase the ultimate proceeds from debt/equity financing. Therefore, subordinate managers will have weaker incentives to constrain earnings management when an organisation is about to go to the capital market to raise debt or equity. Research has also shown that managers will undertake earnings management to influence government investigations. This is consistent with our earlier discussion of ‘political costs’. Godsell, Welker and Zhang (2017) examine the earnings management of European Union organisations around the time of the European Union undertaking antidumping trade investigations. Accounting data is collected as part of these investigations. ‘Dumping’ is deemed to occur when foreign exporters sell goods into the EU at prices lower than the respective goods’ normal prices when sold in the exporting country market. If dumping is seen to occur, and if it is apparent that the domestic industry has suffered financial injury (perhaps reflected by lower reported profits), then action can be taken against the organisation selling the goods into the EU, inclusive of additional taxes/duties being imposed. Specifically, the EU compares accounting data prior to the initiation of the claim with accounting data in the year and, in some cases, the year after or before the investigation is started. Godsell et al. (2017) explain that EU firms petitioning for trade remedies in anti-dumping investigations have incentives to engage in profit-decreasing earnings management in the year of, and year subsequent to, their application for trade relief. The results of their study support this view and are consistent with the view that the petitioning organisations manage earnings in a downward direction to enhance their apparent injury from overseas dumping of products into their country, and increase their probability of success in having action taken against the foreign organisation. However, the authors also find that organisations that are about to raise new debt or equity in the year of, and/or the year after the initiation of anti-dumping investigations, moderate the extent to which they embrace decreasing earnings management. In other related research, Liu, Subramanyam, Zhang and Shi (2018) investigate potential earnings management undertaken by organisations that have been placed on a ‘negative credit watch’. A credit watch occurs when ratings agencies (which provide ratings of various organisations’ credit-worthiness) place particular organisations (that are rated, and which are generally very large) with uncertain changes in credit risk under a formal review process. The organisation is notified by the ratings agency and is placed ‘on watch’ when a downgrade is likely, but not certain. Liu et al. (2018) argue that organisations under negative credit watch have a strong incentive to manage earnings because downgrades in ratings have significant economic implications and because uncertainty in the watch resolution encourages managers to influence the outcome. Liu et al. (2018) find evidence of significant income-increasing accrual management by negative watch firms during the watch period. Further, the income-increasing earnings management is significantly higher than in the respective pre- and post-credit watch periods. Further still, the results indicate that the earnings management during the negative watch favourably influences the outcome of the watch resolution, thereby suggesting that sophisticated users of accounting reports—such as ratings agencies—are actually influenced by opportunistic earnings management. That is, the impacts of the earnings management are not ‘unravelled’ even by such sophisticated users of accounting information. The presence of strong labour unions has also been found to influence the use of earnings management, with managers often trying to use methods to reduce reported income in an endeavour to reduce unions’ ability to justify calls for higher wages for their members. Further, Hamm, Jung and Lee (2018) also argue that organisations with strong labour unions will adopt accounting strategies that tend to reduce the volatility of reported profits. Employees Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 117 10/24/19 12:47 PM 118 PART 2: Theories of accounting (like debtholders) are deemed to perceive volatile employer earnings as a sign that the organisation is at higher risk of failure and therefore is a higher risk. As compensation for the higher risks associated with potentially losing their jobs, employees will generally demand higher wages. The success of such demands is proposed to be linked to the strength of the labour union to which the employees belong. Consequently, Hamm et al. (2018) predict that managers dealing with a stronger labour union have a greater incentive to avoid reporting volatile earnings and they do this by using various accounting accruals in a way that effectively ‘smooths’ reported profits. The results of their study support the prediction. While relatively brief, this discussion of earnings management hopefully emphasises the point that accounting numbers, like profits, are used in a variety of ways and, as a result, managers often have incentives to opportunistically manipulate such numbers. This further highlights the fact that we need to have some healthy scepticism when reviewing an organisation’s financial reports. Worked Example 3.3 considers some incentives associated with earnings management. WORKED EXAMPLE 3.3: Implications associated with the timing of income and expense recognition The reported profits of an organisation will be impacted by various factors, including when particular transactions and events are recognised, and how such transactions and events are measured. REQUIRED Why would managers, especially those who work within large organisations, care about the timing of when income or expenses are recognised? Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. SOLUTION Obviously, whether and how income and expenses are recognised will in turn impact profits. From an objective perspective, managers should be concerned that income is recognised when it has actually been earned and expenses are recognised when they have been incurred (and when there have been related changes in assets and/or liabilities). In terms of why managers might care about when profit is recognised, there are many reasons, including the following: • The news media pay a lot of attention to the profits of larger organisations. Many stakeholders have an interest in these profits and, rightly or wrongly, interpret them as a key measure of the ‘success’ of an organisation. Therefore, because of the attention managers believe profit attracts, they might generally prefer to disclose higher profits. The higher profits might indicate that managers have been performing their duties well. However, as we have already noted, high profits can be used by some stakeholders as an excuse to argue that the organisation is making excessive profits, and that it should decrease the prices it charges for its goods or services and/or increase the payments it makes to its employees. • It is common for managers to receive bonus payments that are linked to profits. For example, the managers might receive a fixed salary plus a bonus that comprises a specified percentage of profit. Because managers would prefer to receive a bonus now rather than later (the present value of a dollar received now is greater than the present value of a dollar received later), managers who have been offered an accounting-based bonus will typically prefer that income (and profits) be recognised earlier than later, and expenses be deferred. However, if the managers believe they will not reach the target level of profits required for a bonus to be paid, they might prefer to defer the recognition of income until the following year, so as to help reach next year’s target and enable a bonus to be paid. • Organisations that borrow funds often sign debt contracts that include clauses (debt covenants) that are linked to accounting numbers. As we know, managers agree to these contracts because they allow the organisation to attract debt funds at a lower cost, as they provide safeguards to lenders. For example, the debt contract might have a requirement that profits must be maintained at a certain level (for example, a specific multiple of total interest costs)—thereby providing a margin of safety that the debtholders will receive the required interest payments—or that a certain level of profit is earned before dividends can be paid to owners. If organisations are close to breaching these contractual requirements, managers will potentially be motivated to recognise income as early as possible so as to ensure compliance with the restrictive covenants. We could give many more reasons as to why managers might care about when income and expenses are recognised, but the point to be made again is that profit is a number that attracts much attention, and it is used within many agreements to which an organisation is party. It is a measure of performance that is of interest to many stakeholders. Therefore, the timing of the recognition of income and expenses is an issue that managers do care about. Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 118 10/24/19 12:47 PM Chapter 3: Theories of financial accounting 119 PAT in summary Up to this point, we have shown the following: ∙ PAT proposes that the selection of particular and alternative accounting methods can be explained either from an efficiency perspective or an opportunistic perspective. At times, it is very difficult to distinguish which perspective best explains a particular organisation’s accounting strategies. The selection of particular accounting methods can affect the cash flows associated with debt contracts, the cash flows associated with management-compensation plans, and the political costs of the firm. ∙ PAT indicates that these effects can be used to explain why managers elect to use particular accounting methods in preference to others. This would be of particular relevance to accountants in practice. For example, auditors need to consider the factors that might have motivated managers to adopt particular accounting methods in preference to others. PAT also provides a basis for explaining why particular organisations might lobby for or against particular proposed accounting requirements. As we know from Chapter 1, when new accounting standards are being developed by the IASB or the AASB, the standard-setters will normally develop a draft accounting standard and then ask for submissions from the public. PAT provides a framework for explaining the lobbying positions taken by the respective respondents and hence provides insights that would be of particular relevance to accounting standard-setters and regulators. ∙ PAT indicates that the use of particular accounting methods might have opposing effects. For example, if a firm adopts a policy that increases income by capitalising an item, rather than expensing it as it is incurred, this might reduce the probability of violating a debt covenant and might also increase accounting-related management bonuses. However, it could also increase the political visibility of the firm on account of higher profits. Managers are assumed to select accounting methods that best balance their conflicting effects, while at the same time maximising their own wealth. Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. Accounting policy selection and disclosure As noted earlier in this chapter, a firm might be involved in many agreements that use accounting numbers relating to profits and assets (for example, an organisation might have instituted a bonus plan where bonuses paid to managers are based on profits, or it might be subject to a debt covenant that restricts its total debt to a certain percentage of its total assets). Hence the decision to expense or capitalise an item might have important financial implications for the organisation and, potentially, for management. It should be noted at this early point in the text that there is much scope in accounting for applying professional judgement in the selection of accounting policies. For example, some companies might use a first-in first-out basis for measuring inventories, while other companies might use a weighted-average approach (both methods are allowed by AASB 102 Inventories). The method selected will have a particular effect on income and assets. This inventory example is only one of numerous choices a firm faces. The old adage that if you put a hundred accountants in a room you might very well get a hundred different figures for the profit or loss of the same business is very true. As we have seen, PAT suggests that the choices that affect profits might in turn have implications for bonus payments to managers, for debt contracts and for political costs. As a result of the choices that confront the accountant, it is imperative that financial statement users are aware of the accounting policies adopted by reporting entities. Comparing the financial results and position of reporting entities that use different accounting methods might be a misleading exercise unless notional adjustments are made to counter the effects of using these different methods and policies. For such adjustments, knowledge of each firm’s accounting policies is necessary. AASB 101 Presentation of Financial Statements requires that a summary of accounting policies be presented in the initial section of the notes to the financial statements. Specifically, paragraph 117 states: An entity shall disclose its significant accounting policies comprising: (a) the measurement basis (or bases) used in preparing the financial statements; and (b) the other accounting policies used that are relevant to an understanding of the financial statements. (AASB 101) In explaining the above requirement, paragraph 118 states: It is important for an entity to inform users of the measurement basis or bases used in the financial statements (for example, historical cost, current cost, net realisable value, fair value or recoverable amount) because the basis on which an entity prepares the financial statements significantly affects users’ analysis. When an entity uses more than one measurement basis in the financial statements, for example when particular classes of assets are revalued, it is sufficient to provide an indication of the categories of assets and liabilities to which each measurement basis is applied. (AASB 101) Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 119 10/24/19 12:47 PM 120 PART 2: Theories of accounting Paragraph 119 further states: In deciding whether a particular accounting policy should be disclosed, management considers whether disclosure would assist users in understanding how transactions, other events and conditions are reflected in reported financial performance and financial position. Each entity considers the nature of its operations and the policies that the users of its financial statements would expect to be disclosed for that type of entity. Disclosure of particular accounting policies is especially useful to users when those policies are selected from alternatives allowed in Australian Accounting Standards. (AASB 101) When a company has changed its accounting policies from one period to the next, comparing its performance in different periods can become difficult. In this regard, AASB 108 Accounting Policies, Changes in Accounting Estimates and Errors requires that, where there is a change in the accounting policy used in preparing and presenting financial statements or group financial statements for the current financial year, and this change has a material effect on the financial statements or group financial statements, the summary of accounting policies is to disclose, or refer to a note disclosing, the nature of the change, the reason for the change and the financial effect of the change. AASB 108, paragraph 14, requires that a change in an accounting policy is to be made only when it: (a) is required by an Australian Accounting Standard; or (b) results in the financial statement providing reliable and more relevant information about the effects of transactions, other events or conditions on the entity’s position, financial performance or cash flows. (AASB 108) LO 3.7 3.7 Accounting policy choice and ‘creative accounting’ Those people responsible for selecting between the different accounting techniques—which, as we have seen, should be explained in the accounting policy notes—might select the alternatives that they believe most effectively and efficiently report the performance of their firm; in other words, they might approach their selection objectively. As paragraph 10 of AASB 108 states: accounting policy notes Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. Notes showing accounting principles, bases of recognition and measurement rules adopted in preparing and presenting financial statements. In the absence of an Australian Accounting Standard that specifically applies to a transaction, other event or condition, management shall use its judgement in developing and applying an accounting policy that results in information that is: (a) relevant to the economic decision-making needs of users; and (b) reliable, in that the financial statement (i) represents faithfully the financial position, financial performance and cash flows of the entity; (ii) reflects the economic substance of transactions, other events and conditions, and not merely the legal form; (iii) is neutral, that is, free from bias; (iv) is prudent; and (v) is complete in all material respects. (AASB 108) By contrast, it is also possible for such individuals to select the policies that best serve their own interests; in other words, they might approach their selection and application of accounting techniques ‘creatively’. The term creative accounting is frequently used in the media. It refers to instances where those responsible for the preparation of financial statements select accounting methods that provide the result desired by the preparers. As we have already seen, PAT provides an explanation of why firms might be creative—or opportunistic—with their accounting (perhaps to increase the rewards paid to managers, to loosen the effects of accounting-based debt covenants or to reduce potential political costs). Indeed, we saw that there were three general hypotheses, these being referred to as: creative accounting Where those responsible for preparing accounts select accounting methods not objectively but according to the result desired by the preparers. ∙ the debt hypothesis ∙ the management bonus hypothesis ∙ the political cost hypothesis. The debt hypothesis predicts that organisations close to breaching accounting-based debt covenants will select accounting methods that lead to an increase in profits and assets. The management bonus hypothesis predicts that managers on accounting-based bonus plans will select accounting methods that lead to an increase in profits. And the Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 120 10/24/19 12:47 PM Chapter 3: Theories of financial accounting 121 political cost hypothesis predicts that firms subject to political scrutiny will adopt accounting methods that lead to a reduction in reported profits. With the range of accounting techniques available—and these techniques will be highlighted throughout this text—account preparers can be creative, yet at the same time follow accounting standards. Although they might not be objective, it might be difficult for parties such as auditors, with an oversight function, to report that the account preparers are doing anything wrong. It is hoped, however, that the vast majority of individuals preparing financial statements place objectivity before self-interest—a hope that is perhaps in conflict with a central assumption of PAT. Griffiths, a British author, devoted an entire book to the issue of creative accounting within the United Kingdom. The book is entitled Creative Accounting: How to Make Your Profits What You Want Them to Be, and in it Griffiths (1987, p. 1) stated: Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. Every company in the country is fiddling its profits. Every set of published accounts is based on books which have been gently cooked or completely roasted. The figures which are fed twice a year to the investing public have all been changed in order to protect the guilty. It is the biggest con trick since the Trojan horse. Any accountant worth his salt will confirm that this is no wild assertion. There is no argument over the extent and existence of this corporate contortionism, the only dispute might be over the way it is described. Such phrases as ‘cooking the books’, ‘fiddling the accounts’ and ‘corporate con trick’ may raise eyebrows where they cause people to infer that there is something illegal about this pastime. In fact this deception is all in perfectly good taste. It is totally legitimate. It is creative accounting. This is a fairly extreme view of creative accounting, and not one necessarily shared by the author of this book. If the output of the accounting system lacks credibility and assuming that such markets as the capital market are efficient, it would be unlikely that they would use the output of the accounting system in the design of contractual arrangements with such a firm. However, evidence clearly indicates that the market does rely on the output of the accounting system. For example, the bond (debenture) trust deeds of large, Australian listed firms, as well as negotiated lending agreements with banks, without any apparent exception, use the output of the accounting system to control and monitor the behaviour of corporate management. While we need to acknowledge that creative accounting does exist, it is reasonable to argue that, with the increased number of accounting standards being issued, the scope for being creative has decreased. Whatever the actual incidence of creative accounting, to consider that all financial statements are developed on an objective basis would be naive. This chapter has discussed how the wealth of the firm, or particular individuals, might be tied to the output of the accounting system. This can be through the existence of accounting-based debt contracts and accounting-based management compensation schemes, both of which are, according to PAT, initially devised to increase the efficient operations of the entity (the efficiency perspective). The existence of political costs, which might be influenced in part by such accounting numbers as ‘profits’, will also affect the value of an organisation. Adopting the opportunistic perspective of PAT, whenever individuals’ wealth is at stake, there is always the possibility that opportunistic actions might override the dictates of objectivity. Certainly, PAT assumes that considerations of self-interest would drive the selection of accounting policies. Whatever the case, creativity might be employed, but hopefully not too often! WHY DO I NEED TO KNOW ABOUT THE CONCEPT OF ‘CREATIVE ACCOUNTING’? According to the Conceptual Framework, general purpose financial reports should provide a representationally faithful portrayal of the transactions and events that have affected the assets and liabilities (and therefore, the equity) of a reporting entity. This means that the depiction of the transactions and events should be complete, neutral and free from error. This in turn means the information is not biased, and there are no material omissions of data. While this is an ideal, the reality is that this does not always occur. Because of private economics-based incentives, managers with the assistance of accountants will, from time to time, manipulate reported financial information to provide an outcome that is beneficial to the organisation, its managers and also potentially the shareholders. They will often do this ‘creatively’ such that it might not be clear to others that the information has been manipulated through creative accounting. As readers of financial statements, it is important for us to know that creative accounting does occur, and to understand why it might occur and how it might occur. To believe that all financial reports are prepared objectively would be naive. Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 121 10/24/19 12:47 PM 122 LO 3.8 PART 2: Theories of accounting 3.8 Some criticisms of Positive Accounting Theory Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. Although PAT received fairly widespread acceptance from a large group of accounting academics, there are nevertheless many researchers who opposed its fundamental tenets. Deegan (1997) provides evidence of the degree of opposition and the intensity of emotion that PAT had generated among its detractors. The following discussion is based on the contents of Deegan (1997). Some of the rather unflattering descriptions of PAT, made by well-regarded accounting academics, have included: It is a dead philosophical movement. (Christenson 1983, p. 7) It has provided no accomplishments. (Sterling 1990, p. 97) It is marred by oversights, inconsistencies and paradoxes. (Chambers 1993, p. 1) It is imperiously dictatorial. (Sterling 1990, p. 121) It is empty and commonplace. (Sterling 1990, p. 130) It is akin to a cottage industry. (Sterling 1990, p. 132) It is responsible for turning back the clock of research 1000 years. (Chambers 1993, p. 22) It provides evidence of doubtful value. (Williams 1989, p. 456) It suffers from logical incoherence. (Williams 1989, p. 459) It is a wasted effort. (Sterling 1990, p. 132) These quoted criticisms clearly indicate the force of emotion that PAT has stimulated among its critics, particularly the normative theorists, who see the role of accounting theory as providing prescription, rather than description. Some of you might not have expected a theory of accounting (such as PAT) to be capable of eliciting such a reaction. As students of accounting, you might find it interesting to ponder why such a theory has made some people so angry— after all, it is just a theory, isn’t it? Although the descriptions of PAT quoted above are extremely negative, it must be kept in mind that there are many researchers who still favour PAT. That is, they still think that the existence of accounting-based debt covenants, management bonus plans and possible political costs will act to influence the choice of accounting methods being used. What should also be kept in mind is that any theory or model of accounting will be based on certain key underlying assumptions about such things as the purposes of accounting, the purposes of accounting research, what drives individual actions, and so forth. Not all researchers will agree with the assumptions, and hence it is to be expected that there will not be total acceptance of any particular theory of accounting. The discussion below will further highlight some of the perceived shortcomings of PAT. Remember that these ‘shortcomings’ would conceivably be challenged by those who favour PAT and/or conduct research under the banner of PAT. One widespread criticism of PAT is that it does not provide prescription and therefore does not provide a means of improving accounting practice. It is argued that simply explaining and predicting accounting practice is not enough. Using a medical analogy, Sterling (1990, p. 130) states: PAT cannot rise above giving the same answers because it restricts itself to the descriptive questions. If it ever asked how to solve a problem or correct an error (both of which require going beyond a description to an evaluation of the situation), then it might go on to different questions and obtain different answers after the previous problem was solved. If we had restricted the medical question to the description of the smallpox virus, for example, precluding prescriptions to be vaccinated, we would need more and more descriptive studies as the virus population increased and mutations appeared. Luckily Edward Jenner was naughtily normative, which allowed him to discover how cowpox could be used as a vaccine so smallpox was eventually eliminated, which made room for different questions on the medical agenda. (From STERLING, R.R., ‘Positive Accounting: An Assessment’, Abacus, vol. 26, no. 2, p. 130 (c) 1990. Reproduced with permission of John Wiley & Sons Ltd) Howieson (1996, p. 31) advances the view that, by failing to provide prescription, Positive Accounting theorists might alienate themselves from practising accountants. As he asserts: an unwillingness to tackle policy issues is arguably an abrogation of academics’ duty to serve the community which supports them. Among other activities, practitioners are concerned on a day-to-day basis with the question of which accounting policies they should choose. Traditionally, academics have acted as commentators and reformers on such normative issues. By concentrating on positive questions, they risk neglecting one of their important roles in the community. Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 122 10/24/19 12:47 PM Chapter 3: Theories of financial accounting 123 A second criticism of PAT is that it is not value-free, as it asserts, but rather is very value-laden (Tinker, Merino & Niemark 1982). If we look at research that has been conducted by applying PAT we will see a general absence of prescription. There is no guidance on what people should do. This is normally justified by Positive Accounting theorists on the basis that they do not want to impose their own views on others. They would prefer to provide information about the expected implications of particular actions and thereafter let people decide for themselves what they should do. For example, they might provide evidence to support a prediction that organisations that are close to breaching accounting-based debt covenants will adopt accounting methods that increase the firms’ reported profits and assets. However, as a number of accounting academics have pointed out, the very act of selecting a theory such as PAT for research purposes is based on a value judgement; deciding what to research is based on a value judgement; believing that all individual action is driven by self-interest is a value judgement; and so on. Hence, no research, whether conducted under PAT or otherwise, is value-free and to assert that it is value-free is, arguably, quite wrong. A third criticism of PAT relates to the fundamental assumption that all action is driven by a desire to maximise wealth. To many researchers such an assumption represents a perspective of humankind that is far too negative. In this regard, Gray, Owen and Adams (1996, p. 75) state that PAT promotes ‘a morally bankrupt view of the world’. Certainly, assuming that all action is driven by a desire to maximise one’s own wealth is not an overly kind assumption about human nature, but—and this is not a justification—such an assumption has been the cornerstone of many past and existing theories used within the discipline of economics. Nevertheless, it is arguably a rather simplistic assumption. Given that everybody is deemed to act in their own interests, the perspective of self-interest has also been applied to the research efforts of academics. For example, Watts and Zimmerman (1990, p. 146) argue that: Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. Researchers choose the topics to investigate, the methods to use, and the assumptions to make. Researchers’ preferences and expected payoffs (publications and citations) affect their choice of topic, methods, and assumptions. Many academics would challenge this view and would argue that they undertake their research because of real personal interest in an issue. Another implication of the self-interest issue is that incorporating this self-interest assumption into the teaching of undergraduate students (as has been done in many universities throughout the world in the economics and accounting fields) might result in students thinking that when they subsequently have to make decisions in the workplace, it is both acceptable and predictable for them to place their own interests above others—after all, that was a key ‘ingredient’ in the theories they were taught. It is perhaps questionable whether such a philosophy is in the interests of the broader community. At the present time, there are many social and ecological problems confronting the planet, not the least of which is climate change. If we are to embrace sustainability in any sort of meaningful way then it is very difficult to understand how efforts to ensure that future generations and the environment will not be disadvantaged by current corporate activities (which would be required for a sustainable future), and quests to maximise current wealth (consistent with ‘self-interest’), can be considered to be mutually compatible. What do you, the reader, think about this issue? Does the teaching of theories that assume self-interest perpetuate the acceptance of self-interest as a guiding motivation? Another criticism of PAT is that, since its beginnings in the 1970s, the theory has not developed greatly. In Watts and Zimmerman (1978) there were three key hypotheses: 1. The debt hypothesis—which typically proposes that organisations that are close to breaching accounting-based debt covenants will select accounting methods that lead to an increase in profits and assets. 2. The bonus-plan hypothesis—which typically proposes that managers on accounting-based bonus schemes will select accounting methods that lead to an increase in profits. 3. The political-cost hypothesis—which typically proposes that firms subject to political scrutiny will adopt accounting methods that reduce reported income. These three hypotheses were considered earlier in this chapter. A review of the recent PAT literature reveals that these hypotheses continue to be tested in different environments and in relation to different accounting policy issues—approximately 40 years after Watts and Zimmerman (1978). In this regard, Sterling (1990, p. 130) asks the following question: What are the potential accomplishments [of PAT]? I forecast more of the same: twenty years from now we will have been inundated with research reports that managers and others tend to manipulate accounting numerals when it is to their advantage to do so. (STERLING, R.R.,1990. Reproduced with permission of John Wiley & Sons Ltd). As a last criticism to consider, it has been argued that PAT is scientifically flawed. As the three hypotheses generated by PAT (mentioned above) are frequently not supported by research but, rather, are falsified, PAT should be rejected from a scientific point of view. Christenson (1983, p. 18) states: We are told, for example, that ‘we can only expect a positive theory to hold on average’ (Watts & Zimmerman 1978, p. 127, n. 37). We are also advised ‘to remember that as in all empirical theories we are concerned with general Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 123 10/24/19 12:47 PM 124 PART 2: Theories of accounting trends’ (Watts & Zimmerman 1978, pp. 288–9), where ‘general’ is used in the weak sense of ‘true or applicable in most instances but not all’ rather than in the strong sense of ‘relating to, concerned with, or applicable to every member of a class’ (American Heritage Dictionary 1969, p. 548) . . . A law that admits exceptions has no significance, and knowledge of it is not of the slightest use. By arguing that their theories admit exceptions, Watts and Zimmerman condemn them as insignificant and useless. However, accounting is a process that is undertaken by people, and the accounting process itself cannot exist in the absence of accountants—it is hard to think of any model or theory that could ever fully explain human action. In fact, to do so would constitute a dehumanising action. Are there any theories of human activity that always hold? What we must appreciate is that theories are simplifications of reality. While the above criticisms do, arguably, have some merit, PAT continues to be used. A number of accounting research journals continue to publish PAT research and many accounting research schools throughout the world continue to teach PAT. What must be remembered is that all theories of accounting will have limitations. They are, of necessity, abstractions of the ‘real world’. Whether we individually prefer one theory of accounting to another will depend on our own assumptions about many of the issues raised in this chapter. In the discussion that follows we turn our attention to normative theories of accounting. As you might expect, such theories are also subject to varied levels of criticism. LO 3.9 3.9 Normative accounting theories Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. As the discussion so far in this chapter has indicated, PAT, the theory based on the works of such individuals as Watts and Zimmerman, and Jensen and Meckling, seeks to explain and predict the selection of particular accounting policies and the implications of that selection. Normative accounting theories, on the normative accounting other hand, seek to provide guidance to individuals to enable them to select the most appropriate theories accounting policies for given circumstances. The Conceptual Framework developed by the IASB Accounting theories that and discussed in Chapter 2 can be considered a normative theory of accounting. Its purpose is to seek to guide individuals provide guidance to the individuals responsible for preparing general purpose financial statements. in selecting the most appropriate accounting The Conceptual Framework identifies the objective of general purpose financial reporting and the policies. qualitative characteristics that financial information should possess. The objective of general purpose financial reporting is, according to the Conceptual Framework, deemed to be: to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions relating to providing resources to the entity. Those decisions involve decisions about: (a) buying, selling or holding equity and debt instruments; (b) providing or settling loans and other forms of credit; or (c) exercising rights to vote on, or otherwise influence, management’s actions that affect the use of the entity’s economic resources. This objective serves as a foundation for the various components that form the Conceptual Framework Project. If we were to disagree with this central objective—and many accounting academics do—we would be unlikely to agree with the subsequent prescriptions provided within the framework. Conceptual frameworks seek to provide recognition and measurement rules within a coherent and consistent framework. As also indicated in Chapter 2, one definition of a conceptual framework was provided by the US Financial Accounting Standards Board as: a coherent system of interrelated objectives and fundamentals that is expected to lead to consistent standards. It prescribes the nature, function and limits of financial accounting and reporting. The use of the term ‘prescribes’ supports the view that the conceptual framework is a normative theory of accounting. The IASB Conceptual Framework identifies a number of qualitative characteristics that financial information should possess (as discussed in Chapter 2). Two main qualitative characteristics are identified as relevance and faithful representation. In relation to faithful representation, the IASB Conceptual Framework states: Financial reports represent economic phenomena in words and numbers. To be useful, financial information must not only represent relevant phenomena, but it must also faithfully represent the phenomena that it purports Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 124 10/24/19 12:47 PM Chapter 3: Theories of financial accounting 125 to represent. To be a perfectly faithful representation, a depiction would have three characteristics. It would be complete, neutral and free from error. Of course, perfection is seldom, if ever, achievable. The Board’s objective is to maximise those qualities to the extent possible. As you have just read about PAT and how PAT researchers work on the assumption that self-interest drives the actions of all individuals—including those individuals who prepare financial statements—it will now be clear to you that, to be consistent, such researchers consider that managers would not be overly motivated to produce financial statements that are ‘complete’ and ‘neutral’ or that ‘represent faithfully’ the transactions of the business—particularly if there are accounting-based contracts in place with associated cash-flow implications. Objectivity and self-interest are, arguably, mutually exclusive. Apart from the Conceptual Framework, there have been a number of other normative accounting theories developed by individual scholars. At certain times, particular theories have received support from various sections of the accounting profession. A period in which a number of notable normative accounting theories were developed was the 1950s and 1960s. During this period, a great deal of the theory development related to issues associated with changing prices and their effect on profits and asset valuation. At this time, most Western countries had high rates of inflation, generating a pressing need for guidance on how to account for changing prices. This need was considered to exist because in times of inflation it was felt that historical-cost accounting overstated accounting profits, which in turn could lead to the payment of excessive dividends, eroding the future operating ability of an organisation. The famous works referred to in Chapter 2 (Moonitz, The Basic Postulates of Accounting, 1961; and Sprouse & Moonitz, A Tentative Set of Broad Accounting Principles for Business Enterprises, 1962) acknowledged the limitations of historical-cost accounting in times of rising prices. They proposed a change from historicalcost accounting to a form of current-value accounting. As previously mentioned in this book, although the theory development was sponsored by the US accounting profession, the theories were not embraced, possibly owing to the fact that they represented a radical departure from practices that existed at the time—and to a large extent still exist today. Dominant normative theories developed in the 1950s and 1960s, all of which addressed issues associated with changing prices, can be broken into the three main classifications (Henderson, Peirson & Brown 1992) of: Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. 1. current-cost accounting 2. exit-price accounting 3. deprival-value accounting. Reflecting the fact that there was no universal agreement on the role of accounting—and there is still none— the alternative normative theories provided conflicting prescriptions. In the discussion that follows we will briefly consider some of the normative theories. We will not consider the actual applications of the various prescriptions in any great detail but, rather, we will consider the main elements of the theories. It should be noted at this point that there is currently little debate on the issues associated with undertaking accounting in periods of changing prices. This might reflect the low rates of inflation we currently experience. Perhaps—and this is sheer conjecture—issues associated with changing prices might again attain prominence if inflation were to reach the heights of past decades. Worked Example 3.4 provides an illustration explaining why a particular theory might be considered to be normative in nature. WORKED EXAMPLE 3.4: The Conceptual Framework as a normative theory of accounting The Conceptual Framework is an important framework for general purpose financial reporting. REQUIRED Explain why the Conceptual Framework is considered to be a normative theory of accounting. SOLUTION First, we can consider it to be a theory because it has been carefully developed based on clear assumptions about the objectives of general purpose financial reporting, the users of such reports and their level of expertise. These assumptions all link together to provide various prescriptions that are logically derived. While there will be various people who disagree with some, or many, aspects of the Conceptual Framework, the framework is nevertheless coherent and provides a clear framework for general purpose financial reporting. It certainly represents much more than a ‘hunch’ about how to report. It is a normative theory because it provides prescription about how general purpose financial reporting should be undertaken. It does not seek to predict or explain practice, as would a positive theory. Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 125 10/24/19 12:47 PM 126 PART 2: Theories of accounting Current-cost accounting current-cost accounting Current-cost accounting was advocated by many accounting researchers, including Edwards and Bell in the USA (The Theory and Measurement of Business Income, 1961) and Mathews and Grant in Australia (Inflation and Company Finance, 1958). Although there are variations within the different models of current-cost accounting, the general aim of the theory is to provide a calculation of income that, after adjusting for changing prices, could be withdrawn from the entity yet still leave the physical capital of the entity intact. Such measures of income are often promoted as true measures of income. As Henderson, Peirson and Brown (1992, p. 40) state: A system of accounting that measures the value of goods and services in terms of their current costs. The essential characteristics of true income theories is that they propose a single measurement basis for assets and a consequent single or unique measure of income (profit). The resulting income measure is regarded as the correct or true measure of income. Almost by definition other measures of income are incorrect or untrue and must, therefore, be misleading. The true measures of income should be suited to the needs of all users of the financial statements. Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. For the purposes of illustration, assume that a company started the period with assets of $50 000. Let us assume also that there are no liabilities, so that the owners’ equity also equals $50 000. During the period, the business sells all of its assets for $70 000. Under historical-cost accounting the profit would be $20 000 and the closing owners’ equity would be $70 000, which would be matched by assets of $70 000 in the form of cash. If the $20 000 was withdrawn in the form of dividends, under historical-cost accounting the owners’ equity of the business would remain as it was at the beginning of the period. However, if we were to adopt current-cost accounting, the profit would not necessarily be the same. If, owing to rising prices, it cost $60 000 to replace the assets that were sold (their ‘current cost’), under current-cost accounting, the profit would be only $10 000, as $60 000 would need to be retained to keep the physical capital of the firm intact. The maintenance of the firm’s physical capital or operating capacity is a central goal of current-cost accounting. Proponents of this normative theory argue that by valuing assets (and this would translate to expense recognition) at their current costs—in some models based on replacement cost—a ‘truer’ measure of profit is provided than is reflected by the historical-cost system. A frequently raised criticism of current-cost accounting is that it introduces an unacceptable amount of subjectivity into the accounting process, as some assets will not have a readily accessible ‘current cost’. However, advocates of the approach argue that the increased relevance of the information more than offsets any disadvantages associated with its reliability, compared with historical-cost data. Exit-price accounting Continuously Contemporary Accounting (CoCoA) One of the most famous expositions of a normative accounting theory was developed by the Australian researcher Raymond Chambers. He labelled his theory Continuously Contemporary Accounting (CoCoA). The theory was developed principally between 1955 and 1965. Chambers (1955) advanced the view that accounting research and accounting theory should be developed with an underlying objective of providing a better system of accounting, rather than simply describing or explaining contemporary practices. (Until his death in 1999, Chambers continued to be a strong opponent of positive accounting research.) The most fully developed exposition of Chambers’ theory was provided in his publication Accounting, Evaluation and Economic Behavior, released in 1966. The theory relies on assessments of the exit or selling prices of an entity’s assets and liabilities—hence it is labelled an exit-price theory. The development of CoCoA was based on the key assumptions that: A normative theory that proposes an approach to accounting that relies on measuring the exit prices of the entity’s assets and liabilities. exit-price theory Normative theory of accounting which prescribes that assets should be valued on the basis of exit prices and that financial statements should function to inform users about an organisation’s capacity to adapt. ∙ firms exist to increase the wealth of the owners ∙ successful operations are based on the ability of an organisation to adapt to changing circumstances ∙ the capacity to adapt will be best reflected by the monetary value of the organisation’s assets, liabilities and equities at reporting date, where the monetary value is based on the current exit or selling prices of the organisation’s resources (their current cash equivalent). According to Chambers, a central objective of accounting should be to provide information about an entity’s ability to adapt to changing circumstances or, as he referred to it, an organisation’s capacity to adapt. Capacity to adapt is directly tied to the cash that could be obtained if an entity sold its assets. Chambers’ theory advocated that an entity’s balance sheet (now also referred to as a statement of financial position) should base the value of all assets on their respective selling prices. If an asset is not readily saleable (and therefore does not have a sales price), it does not contribute capacity to adapt A measure, promoted by Chambers, tied to the cash that could be obtained if an entity sold its assets. Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 126 10/24/19 12:47 PM Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. Chapter 3: Theories of financial accounting 127 to an entity’s capacity to adapt to changing circumstances. Further, the profit for a period should also be tied to the changes in the current exit prices of the organisation’s assets and, as such, profit as a measure of performance should reflect changes in an organisation’s capacity to adapt. Chambers proposed that his model of accounting would provide information that would be useful to all financial statement users. Chambers’ theory of accounting (CoCoA) is often referred to as a ‘decision usefulness approach’ to accounting theory development, in which he takes a decision-models approach. Proponents of the decision-models approach develop models based on the researcher’s own perceptions about what information is necessary for efficient decision making. (By contrast, an approach that develops models based on asking other individuals what information they seek, perhaps through using questionnaires, would be referred to as a decision-makers emphasis.) Chambers’ decision-models approach considers the decision-making requirements of financial statement users to be the primary reason for developing a particular accounting system. This necessarily requires an initial judgement on what kinds of information are necessary for informed decision making. Chambers takes the responsibility for making such judgements on behalf of financial statement users. Under CoCoA, organisations that cannot adapt are considered relatively more likely to fail. The more liquid or saleable an organisation’s assets, the greater the perceived capacity to adapt. If an organisation has very specialised assets, which do not have a secondary market, such an organisation is considered to have a low capacity to adapt. If circumstances/markets change, an organisation with very specialised assets would be more likely to fail. Capacity to adapt should be reflected by the entity’s financial statements, which will highlight current cash adaptive capital. To this end, and as noted above, Chambers prescribed that all assets should be equivalents recorded at their current cash equivalents. Current cash equivalents were represented by the Represented by the amounts expected to be generated by selling the assets. The net sales or exit prices were to be amount that would be determined on the basis of an orderly sale. Within the model, the balance sheet should clearly show expected to be generated by selling an asset. the expected net selling prices of all of the entity’s assets—net selling prices would acknowledge any costs that would be incurred in making a sale. Adaptive capital would be represented by the total net selling prices of the various assets, less the amount of the firm’s liabilities. Profit would reflect the change in the organisation’s capacity to adapt that had occurred since the beginning of the period. Because the valuation of assets is to be based on their current cash equivalents, depreciation expenses would not be recognised within CoCoA. According to the Chambers model, if assets cannot be separately sold, for the purposes of determining the organisation’s financial position they are deemed to have no value. This in itself was considered to be too extreme for many accounting practitioners and researchers, and represented a radical alternative to the existing accounting practices. Assets such as goodwill or some work in progress would be assessed as having no net selling price and therefore would be attributed zero value. Chambers argued that by using current selling prices, accounting reports would be objective and understandable to readers. By using a consistent valuation approach, it was also more valid or even logical to add the values of the various assets together to get an overall total asset value. This can, of course, be compared with the system we have today in which alternative classes of assets are to be valued in a variety of ways but, nevertheless, are added together for the purpose of financial statement presentation. Chambers argued that people can easily understand what valuation on the basis of net selling prices means. Under CoCoA, assets are not valued on the basis of arbitrary cost allocations or amortisation nor on the basis of directors’ valuations. As you would expect, there are many criticisms of CoCoA, such as that it does not consider the ‘value in use’ of assets. If an asset is retained, rather than sold, its value in use would likely be greater than its current exit price. This could apply particularly in the case of specialised resources such as a blast furnace that is generating positive returns. It has a positive value in use but if it cannot be sold separately, for the purposes of CoCoA it has no value. As Chambers might argue, however, if something generates a positive return, it should have a market and a corresponding market value. Another criticism of CoCoA is that, in valuing assets at their perceived sales value, it is implied that the firm intends to liquidate the assets. Obviously, this might not be the case. Nevertheless, Chambers’ model does provide useful information for determining an organisation’s capacity to adapt—which he argues is a central objective of accounting. Chambers’ model has also been criticised on the basis that the exit prices are determined by the price that could be achieved in an orderly sale. These sales might be at different times and might not reflect values at reporting date. As values are based on an opinion of perceived selling prices, it has also been argued that such financial statements might not be useful for monitoring the firm’s management. Deprival-value accounting A further normative (or prescriptive) accounting theory that we will briefly consider is deprival-value accounting. Deprival value itself can be defined as the value to the business of particular assets. It represents the amount of loss Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 127 10/24/19 12:47 PM 128 PART 2: Theories of accounting that might be incurred by an entity if it were deprived of the use of an asset and the associated economic benefits the asset generates. The selling price of an item less the costs that In 1975, deprival-value accounting was recommended by the UK Sandilands Committee. are incidental to making The deprival value of an asset to be reported in the financial statements would be determined by the sale. considering: the net selling price of the asset; the present value of the future cash flows that the asset will generate; or the asset’s current replacement cost. The deprival value is the lower of current replacement cost and the greater of the net selling price and present value (value in use). present value The value of an item to be For example, if an asset could be sold for a net amount of $100 or used to generate a present value received or paid for in the of $120, the best use of the asset would be to keep it and use it to generate future cash flows. The future expressed in terms deprival value is then the lesser of the present value ($120) and the cost to replace the asset. To of its value today. adopt this form of accounting would require all assets and liabilities to be considered separately in terms of their deprival value to the business. current replacement Some criticisms of deprival-value accounting have included the concern that different cost valuation bases would be used within a single financial statement—such as selling prices, presentA valuation method value calculations and replacement costs. This can be compared with Chambers’ CoCoA, which based on the current replacement cost of prescribes one method of valuation—net selling prices. It has also been argued that the valuation an item rather than its procedures would be particularly costly and time-consuming, given that more than one method of historical cost. valuation might have to be used for particular assets. It might also not be clear which valuation approach should be adopted for a particular type of asset. The aim of the above brief discussion of three different normative theories of accounting (which tell us how we should account) is to show the difference between normative and positive theories of accounting. The following discussion focuses on yet another group of theories, classified as systems-oriented theories. net selling price Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. LO 3.10 3.10 Systems-oriented theories to explain accounting practice Apart from PAT and the normative accounting theories discussed briefly above, there are numerous other theories applicable to the accounting process. What should be stressed is that, as mentioned previously, theories that try to explain why certain phenomena occur are abstractions of reality, and no particular theory can be expected to provide a full account or description of a particular phenomenon. Hence it is sometimes useful to consider the perspectives or insights provided by alternative theories. In some cases, different researchers study the same phenomenon but from different theoretical perspectives. For example, some researchers operating within the Positive Accounting Theory paradigm (such as Ness & Mirza 1991) argue that the voluntary disclosure of social responsibility information can be explained as a strategy to reduce political costs. Social responsibility reporting has also been explained from a Legitimacy Theory perspective (for example, Patten 1992; Deegan & Islam 2014; Deegan 2019), from an Institutional Theory Perspective and from a Stakeholder Theory perspective (for example, Roberts 1992). The choice of one theoretical perspective in preference to others will, at least in part, be due to value judgements on the part of the authors involved. As O’Leary (1985, p. 88) states: Theorists’ own values or ideological predispositions may be among the factors that determine which side of the argument they will adopt in respect of disputable connections of a theory with evidence. One branch of accounting-related theories can be referred to as systems-oriented theories. According to Gray, Owen and Adams (1996, p. 45): systems-oriented theories Theories that explain the role of information and disclosure in managing the relationships between an organisation and the communities with which it interacts. a systems-oriented view of the organisation and society . . . permits us to focus on the role of information and disclosure in the relationship(s) between organisations, the State, individuals and groups. From a systems-based perspective (or as it is also referred to, a ‘general systems theory’ perspective), an entity is assumed to be influenced by the society in which it operates and in turn to have an influence on society. This is simplistically represented in Figure 3.1. According to Gray, Adams and Owen (2014, p. 17), a system is a conception of a part of the world that recognises explicitly that the part is (a) one element of a larger whole with which it interacts (that is, it influences and is itself influenced by); and (b) also contains other parts that are intrinsic to it. Three theories with a systems-based perspective are Stakeholder Theory, Legitimacy Theory and Institutional Theory. Within these theories, accounting disclosure policies are considered to constitute a strategy to influence Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 128 10/24/19 12:47 PM Chapter 3: Theories of financial accounting 129 Figure 3.1 Interest groups The public Employees Industry bodies The organisation Consumers The organisation viewed as part of a wider social system Investors Suppliers Media Government Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. (or, perhaps, manage) the relationships between the organisation and other parties with which it social-responsibility interacts. In recent times, Stakeholder Theory, Legitimacy Theory and Institutional Theory have disclosures been applied extensively to explain why organisations might make certain social-responsibility Disclosures of information about the interaction disclosures within their annual reports or sustainability reports, rather than why they might elect of an organisation with to adopt particular financial accounting methods. The theories could, however, also be applied to its physical and social explain, at least in part, why companies adopt particular financial accounting techniques. environment. Social-responsibility disclosures themselves can relate, among other things, to information about the interaction of an organisation with its physical and social environment, including the community, the natural environment, human resources, energy and product safety. Stakeholder Theory, Legitimacy Theory and Institutional Theory will be discussed in greater detail in Chapter 32, which considers social disclosures. However, as this chapter considers accounting-related theories, some attention here is warranted. We will briefly consider Stakeholder Theory, Legitimacy Theory and Institutional Theory in turn below. 3.11 Stakeholder Theory LO 3.11 Stakeholder Theory can be broadly broken up into two branches—an ethical (or normative) branch and a managerial (or positive) branch. The ethical branch adopts the view that all stakeholders have certain intrinsic rights (for example, to safe working conditions and fair pay)—as well as rights to information—and these rights should not be violated. As Hasnas (1998, p. 32) states: Stakeholder Theory Perspective that considers the importance for an When viewed as a normative (ethical) theory, Stakeholder Theory asserts that, regardless of whether organisation’s survival of stakeholder management leads to improved financial performance, managers should manage the satisfying the demands of business for the benefit of all stakeholders. It views the firm not as a mechanism for increasing the its various stakeholders. stockholders’ financial returns, but as a vehicle for coordinating stakeholder interests and sees management as having a fiduciary relationship not only to the stockholders, but to all stakeholders. According to the normative Stakeholder Theory, management must give equal consideration to the interests of all stakeholders and, when these interests conflict, manage the business so as to attain the optimal balance among them. This of course implies that there will be times when management is obliged to at least partially sacrifice the interests of the stockholders to those of the other stakeholders. Hence, in its normative form, the Stakeholder Theory does imply that business has true social responsibilities. A stakeholder can be broadly defined as ‘any group or individual who can affect or is affected by the achievement of the firm’s objectives’ (Freeman 1984). Stakeholders would include shareholders, employees, customers, lenders, suppliers, local charities, various interest groups and government. Depending upon how broad we wish to define stakeholders, stakeholders also include future generations and the environment. From this perspective, the organisation is seen as part of a larger social system, as shown in Figure 3.1. Within the ethical branch of Stakeholder Theory, there Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 129 10/24/19 12:47 PM 130 PART 2: Theories of accounting is also the view that all stakeholders have many rights, including a right to be provided with information about how the organisation is affecting them (perhaps through pollution, community sponsorship, provision of employment, safety initiatives, etc.), even if they choose not to use the information, and even if they cannot directly affect the survival of the organisation. The fact that authors adopting an ethical view espouse normative perspectives of how they believe organisations should act towards their stakeholders does not mean that these perspectives will actually coincide with how organisations behave. Hence the various ethical perspectives cannot be validated by empirical observation—as might be the case if the researchers were adopting descriptive or predictive (positive) theories about organisational behaviour. As Donaldson and Preston (1995, p. 67) state: In normative uses, the correspondence between the theory and the observed facts of corporate life is not a significant issue, nor is the association between stakeholder management and conventional performance measures a critical test. Instead a normative theory attempts to interpret the function of, and offer guidance about, the investor-owned corporation on the basis of some underlying moral or philosophical principles. Turning our attention away from the ethical (normative) branch and to the managerial (or positive) branch of Stakeholder Theory, we see that this branch seeks to explain and predict how an organisation will react to the demands of various stakeholder groups. As the research based on this branch of Stakeholder Theory is used to make predictions, it is reasonable to assess the validity of such research on the basis of its correspondence with actual practice. Within the managerial branch of Stakeholder Theory (see, for example, Roberts 1992), the organisation identifies its group of stakeholders, particularly those that are considered to be important to the ongoing operations and survival of the business. The greater the importance of the stakeholders, the greater will be the expectation that the management of the firm will take actions to ‘manage’ the relationships with those stakeholders (hence why it is called the ‘managerial branch’). As the expectations and power relativities of the various stakeholder groups can change, organisations must continually adapt their operating and disclosure strategies. Roberts (1992, p. 598) states that: Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. A major role of corporate management is to assess the importance of meeting stakeholder demands in order to achieve the strategic objectives of the firm. As the level of stakeholder power increases, the importance of meeting stakeholder demands increases also. The power of stakeholders (for example, owners, creditors or regulators) to influence corporate management is viewed as a function of stakeholders’ degree of control over resources required by the organisation (Ullmann 1985). The more critical the stakeholder-controlled resources are to the continued viability and success of the organisation, the greater the expectation that stakeholder demands will be addressed. A successful organisation is considered to be one that satisfies the demands (sometimes conflicting) of the various powerful stakeholder groups. In this regard Ullmann (1985, p. 2) states: Our position is that organisations survive to the extent that they are effective. Their effectiveness derives from the management of demands, particularly the demands of interest groups upon which the organisation depends. Stakeholders’ power will be stakeholder–organisation specific, and might be tied to such things as command of limited resources (finance, labour), access to influential media, ability to legislate against the company, or ability to influence the consumption of the organisation’s goods and services. The behaviour of various stakeholder groups is considered a constraint on the strategies developed by management to best match corporate resources with the entity’s environment. The strategy of pursuing profits for the benefit of investors is not sufficient in or by itself. Within the variant of Stakeholder Theory that adopts a managerial (or positive) perspective, information, including financial accounting information and information about the organisation’s social performance, is a tool in controlling the sometimes conflicting demands of various stakeholder groups. Gray, Adams and Owen (2014, p. 85) state: Here (under this perspective), the stakeholders are identified by the organisation of concern, by reference to the extent to which the organisation believes the interplay with each group needs to be managed in order to further the interests of the organisation (what Mitchell et al., 1997, call ‘salience’). The more important (salient) the stakeholder to the organisation, the more effort will be exerted in managing the relationship. Information—including financial accounting and social accounting—is a major element that can be employed by the organisation to manage (or manipulate) the stakeholder in order to gain their support and approval (or to distract their opposition and disapproval). As the level of stakeholder power increases, the importance of meeting stakeholder demands increases. Some of this demand might relate to the provision of information about the activities of the organisation. According to Ullmann (1985), the greater the importance to the organisation of the stakeholder’s resources/support, the greater the probability that a particular stakeholder’s expectations will be accommodated within the organisation’s operations. According to this Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 130 10/24/19 12:47 PM Chapter 3: Theories of financial accounting 131 perspective, various activities undertaken by organisations, including public reporting, will relate directly to the expectations of particular stakeholder groups. Furthermore, organisations will have an incentive to disclose information about their various programs and initiatives to the stakeholder groups concerned to clearly indicate that they are conforming with those stakeholders’ expectations. Organisations must necessarily balance the expectations of various stakeholder groups. In relation to corporate social disclosures, Roberts (1992, p. 599) states: social responsibility activities are useful in developing and maintaining satisfactory relationships with stockholders, creditors, and political bodies. Developing a corporate reputation as being socially responsible through performing and disclosing social responsibility activities is part of a strategy for managing stakeholder relationships. Stakeholder Theory (of the positive, or managerial, variety) does not directly provide prescriptions about what information should be disclosed, other than indicating that the provision of information, including information within an annual report or a sustainability report, can, if thoughtfully considered, be useful for the continued operations of a business entity. Within the managerial branch of Stakeholder Theory, it is a stakeholder’s control over limited resources that are required by an organisation that influences whether specific information is provided to that stakeholder—not issues associated with rights to information. The insights provided by Stakeholder Theory are of relevance to various people within the accounting profession. For example, accounting regulators will have a better understanding of why some disclosures are being voluntarily made by organisations (perhaps because they are demanded by powerful stakeholders) while other seemingly important or relevant disclosures are not being made (perhaps the related information is sought only by stakeholders who are impacted by the operations of the organisation, but they do not have the necessary power to compel the organisation to make disclosures). This has implications for the need to potentially legislate particular disclosures. Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. Diverse stakeholders and the production of ‘multiple accounts’ (or ‘dialogic accounts’) Following on from the above material, different stakeholder groups will probably have different views about the responsibilities and accountabilities of an organisation. Different stakeholder groups will also probably have different information demands because of different interests in the various aspects of the operation and performance of an organisation. All forms of accounting typically involve an element of judgement by those making the disclosures, and this is even more so when the form of reporting is largely unregulated, as is the case with much social and environmental/ sustainability reporting (which we address in Chapter 32). Therefore, the managers of an organisation might—through their disclosures—provide a particular perspective of their organisation’s performance (potentially a partisan or biased perspective), but such perspectives of performance might not be shared by other stakeholder groups. Realistically, there could be an element of bias to the reporting being undertaken. For example, financial reporting—which is the focus of this book—provides information that is believed to be particularly relevant to investors, lenders and creditors. Other categories of stakeholders might not be as interested in such information, but might be interested instead in different aspects of the organisation’s performance. However, there is some argument that when organisations prepare their corporate social responsibility/sustainability reports, and particularly where there are contested perspectives about an organisation’s social and environmental performance (that is, where different stakeholders do not share the same view as management about how ‘well’ the organisation is performing), then the alternative views held by other stakeholders should arguably also be included within the reports being released by the organisation. For example, if an organisation produces social information relating to how it has advanced the interests of its employees, possibly through implementing various educational or training initiatives, or by introducing policies that assist in the employment of people with disabilities, it might also be useful to provide the views of particular labour union officials—who are stakeholders other than management—about whether they also believe the organisation has been successful in promoting the interests of employees. Brown (2009) provides an insightful discussion of this possibility, referring to the concept of dialogic accounting and focusing on the sustainability area for illustrative purposes. By dialogic accounting, Brown is referring to a situation in which there is typically more than one ‘logic’ that could be employed to assess and subsequently report information about organisational performance, and these different logics (based on different perspectives about what aspects of performance are important, or not, to different stakeholders) could be used to develop different forms of ‘accounts’. Producing dialogic accounts encourages debate and enhances the possibilities for revisions in how managers manage the organisation. Brown (2009) provides an interesting comparison of dialogic accounting with monologic accounting—monologic accounts represent only one view or logic, this being that of the managers. As she explains, monologic accounting reflects the accounting traditions currently in place, wherein only the manager’s perspective of performance is reported Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 131 10/24/19 12:47 PM 132 PART 2: Theories of accounting to external stakeholders. This is the approach to reporting to which we are accustomed and which is traditional. That is, it is the reports prepared and endorsed by managers that are provided to the stakeholders of an organisation. However, according to Brown, the non-reporting of other stakeholders’ perspectives inevitably provides bias in situations where there are conceivably alternative viewpoints. According to Brown (2009, p. 317), dialogic accounting, in recognising the existence of different views of organisational performance, allows for a situation where different and sometimes conflicting views are allowed to coexist. Pursuant to this view, corporate reporting could become a vehicle to foster democratic interaction. The aim of dialogic accounting is not necessarily to replace one dominant form of accounting with another, but rather to encourage the development and use of more multidimensional accounting and accountability systems, capable of engaging a variety of perspectives and facilitating wide-ranging discussion and debate about organisational matters. This is a very interesting suggestion, one that runs counter to the views often proffered by many accounting practitioners and researchers, wherein there is presumed to be only one view of the world that can be captured by managers and objectively reflected within accounting reports. As Brown (2009, p. 318) states: Given the essentially contestable nature of sustainability, new accountings should not be aimed at producing incontrovertible accounts. Societal worth should be judged not in terms of the expert production of the ‘right answer’ but in the facilitation and broadening of debate . . . Accountants need to develop systems that prevent premature closure and which infuse debate and dialogue, facilitating genuine and informed citizen participation in decision making processes . . . A framework of a dialogical approach would: recognise ideological assumptions; avoid monetary reductionism; be open about the objective and contestable nature of calculations; enable accessibility of nonexperts; ensure effective participatory processes; be attentive to power relations; and recognise the transformative potential of dialogic accounting. According to Brown (2009), a form of accounting that embraces a dialogical approach will have considerable transformative potential in areas such as sustainable development. Again, the views embodied by Brown (2009) would seem to be of great value in informing debate to extend corporate accountability, and to project different views about corporate performance and success. However, despite its merits, it is probably unlikely that the current monologic practices, which tend to dominate reporting practices, will be displaced any time soon by dialogical approaches. Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. WHY DO I NEED TO KNOW ABOUT THE INSIGHTS PROVIDED BY STAKEHOLDER THEORY? Stakeholder Theory can be broken down into two broad branches, both of which can provide valuable insights. The ethical branch of Stakeholder Theory prescribes that all stakeholders have rights, including the right to information, regardless of whether they have ‘power’. The more they are impacted by the operations of an organisation, the more consideration that should be given to the demands and expectations of the stakeholder. It is important that all stakeholders are treated ethically, and a knowledge of the insights provided by the ethical branch of Stakeholder Theory reinforces to us the need to think in an ethical way about different stakeholders. The managerial branch of Stakeholder Theory seeks to explain the actions of managers, including their reporting decisions. Under this branch of Stakeholder Theory, managers are generally predicted to respond to the demands and expectations of those stakeholders most able to impact the operations of the organisation (those that have ‘power’). Knowledge of this branch of Stakeholder Theory is useful to us in understanding why managers might be making some disclosures and not others. Worked Example 3.5 is an illustration that applies a consideration of stakeholders to the decision to report information. WORKED EXAMPLE 3.5: Identification of stakeholders and their information needs Organisations are often said to have many and varied stakeholders with different information demands. REQUIRED (a) Who is a stakeholder? (b) How will the managers of an organisation determine what information to disclose to which stakeholders? Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 132 10/24/19 12:47 PM Chapter 3: Theories of financial accounting 133 SOLUTION (a) We defined a stakeholder earlier as ‘any group or individual who can affect or is affected by the achievement of the firm’s objectives’. Some stakeholders will have power over the organisation, others will not. (b) The answer to this is linked to the responsibilities and accountabilities that managers accept towards the stakeholders of an organisation. If managers are preoccupied with satisfying the information demands of powerful stakeholders, they will simply determine, through some form of engagement, what information the powerful stakeholders want, and supply that. However, if managers take a more ethical perspective towards their stakeholders, they will think about the impacts created for, or to, a wider group of stakeholders and will provide a variety of information about the various economic, social and environmental impacts upon those stakeholders together with information about what is being done to address or control such impacts. 3.12 Legitimacy Theory Legitimacy Theory is very closely linked to Stakeholder Theory. It posits that organisations continually seek to ensure that they operate within the bounds and norms of their respective societies; that is, they attempt to ensure that their activities are perceived by outside parties to be ‘legitimate’. These bounds and norms, rather than being fixed, are subject to change, requiring the organisation to be responsive to the environment in which it operates. Lindblom (1993) distinguishes between legitimacy, which is considered to be a status or condition, and legitimation, which she considers to be the process that leads to an organisation being adjudged legitimate. According to Lindblom (p. 2), legitimacy is: LO 3.12 Legitimacy Theory Theory which proposes that organisations always seek to ensure that they operate within the bounds and norms of their societies. . . . a condition or status which exists when an entity’s value system is congruent with the value system of the larger social system of which the entity is a part. When a disparity, actual or potential, exists between the two value systems, there is a threat to the entity’s legitimacy. Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. Legitimacy is a relative concept—it is relative to the social system in which the entity operates and is both time-specific and place-specific. Corporate activities that are ‘legitimate’ in a particular place and time might not be legitimate at a different point in time, or in a different place (for example, what is legitimate behaviour in one country might not be legitimate in another). As Suchman (1995, p. 574) states: Legitimacy is a generalised perception or assumption that the actions of an entity are desirable, proper, or appropriate within some socially constructed system of norms, values, beliefs, and definitions. Within Legitimacy Theory, ‘legitimacy’ is considered to be a resource upon which an organisation depends for its survival (Dowling & Pfeffer 1975; O’Donovan 2002). It is something that is conferred upon the organisation by society, and it is something that is desired or sought by the organisation. However, unlike many other ‘resources’, it is a ‘resource’ that the organisation is considered to be able to impact or manipulate through various disclosure-related strategies (Woodward, Edwards & Birkin 1996). Researchers that use Legitimacy Theory often link ‘legitimacy’ to the idea of a ‘social social contract contract’. That is, they rely on the notion that there is a social contract between an organisation Considered to be and the society in which it operates. An organisation is deemed to be operating with ‘legitimacy’ an implied contract when its operations are perceived by society to be complying with the terms or requirements of the constituted by the expectations that society ‘social contract’. The social contract is not easy to define, but the concept is used to represent the holds about the conduct of multitude of implicit and explicit expectations that society has about how an organisation should an organisation. conduct its operations. The law is considered to provide the explicit terms of the social contract, while other, non-legislated societal expectations embody the implicit terms of the contract. It is assumed that society allows the organisation to continue operations as long as it generally meets society’s expectations. Legitimacy Theory emphasises that the organisation must appear to consider the rights of the public at large, not merely those of its investors. Organisations are not considered to have any inherent right to resources. Legitimacy (from society’s perspective) and the right to operate go hand in hand. As Mathews (1993, p. 26) states: The social contract would exist between corporations (usually limited companies) and individual members of society. Society (as a collection of individuals) provides corporations with their legal standing and attributes and Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 133 10/24/19 12:47 PM 134 PART 2: Theories of accounting the authority to own and use natural resources and to hire employees. Organisations draw on community resources and output both goods and services and waste products to the general environment. The organisation has no inherent rights to these benefits and in order to allow their existence, society would expect the benefits to exceed the costs to society. The idea of a social contract is not new—it was discussed by philosophers such as Thomas Hobbes (1588–1679), John Locke (1632–1704) and Jean-Jacques Rousseau (1712–1778). Society expects the organisation to comply with the terms of this ‘contract’ and, as noted above, these expressed or implied terms are not static. As Shocker and Sethi (1974, p. 67) state: Any social institution—and business is no exception—operates in society via a social contract, expressed or implied, whereby its survival and growth are based on: (1) the delivery of some socially desirable ends to society in general, and (2) the distribution of economic, social, or political benefits to groups from which it derives its power. In a dynamic society, neither the sources of institutional power nor the needs for its services are permanent. Therefore, an institution must constantly meet the twin tests of legitimacy and relevance by demonstrating that society requires its services and that the groups benefiting from its rewards have society’s approval. As indicated in Deegan and Rankin (1996, p. 54), pursuant to Legitimacy Theory, if an organisation cannot justify its continued operation, the community may, in a sense, revoke the organisation’s ‘contract’ to continue its operations. This might occur through consumers reducing or eliminating the demand for the products of the business, factor suppliers eliminating the supply of labour and financial capital to the business, or constituents lobbying government for increased taxes, fines or laws to prohibit the actions that do not conform to the expectations of the community. The notion of a social contract is something corporate managers have been referring to for many years. For example, in an article entitled ‘Westpac chief admits banks failed in the bush’, which appeared in The Australian on 20 May 1999 (by Sid Marris), it was stated: Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. The rush by banks to shut branches in rural areas over the past decade was a ‘mistake’ and broke ‘the social contract’ with the community, Westpac executive Michael Hawker said. In a more recent newspaper article addressing banks, and following the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry (also known as the Hayne Royal Commission), it was reported in an article entitled ‘Greed defined but little else to report’ (by Adele Ferguson, The Sydney Morning Herald, 29 September 2018, p. 13) that: Australians have waited years for a royal commission. Customers ripped off by the banks have waited even longer as the banks dragged their heels on remediation programs and made low-ball offers. This misconduct has been going on for years. There is nothing new in that. A decade ago Commonwealth Bank whistleblower Jeff Morris became a financial planner and encountered a culture focused on sales and profits. As Hayne found, ‘It was at the expense of basic standards of honesty.’ Morris found that profits equalled greed due to metricated bonuses at all levels. The same was going on at the other banks. They had become sales machines and by doing so they had broken their social contract with their customers and callously destroyed lives. Given the potential costs associated with conducting operations that are deemed to be outside the terms of the social contract, Dowling and Pfeffer (1975) state that organisations will take various actions to ensure that their operations are perceived to be legitimate. One such action would be—and this is where we get to the theory’s relevance to accounting—to provide disclosures, perhaps within the annual report. Hurst (1970) suggests that one of the functions of accounting, and subsequently accounting reports, is to legitimate the existence of the corporation. Within such a perspective, the strategic nature of financial statements and other disclosures is emphasised. From the perspective provided by Legitimacy Theory, it is important not only that an organisation operate in a manner consistent with community expectations (that is, consistent with the terms of the social contract), but also that the organisation disclose information to demonstrate that it is complying with community expectations. That is, if an organisation undertakes actions that conform to community expectations, this in itself is not enough to bring legitimacy to the organisation—it must make disclosures to show clearly that it is complying with community perceptions. It is society’s perceptions of an organisation’s actions that are important in establishing legitimacy and not necessarily the actual actions themselves. Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 134 10/24/19 12:47 PM Chapter 3: Theories of financial accounting 135 Because community expectations can change, the organisation must make disclosures to show that it is also changing. In relation to the dynamics associated with changing community expectations, Lindblom (1993, p. 3) states: Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. Legitimacy is dynamic in that the relevant publics continuously evaluate corporate output, methods, and goals against an ever evolving expectation. The legitimacy gap will fluctuate without any changes in action on the part of the corporation. Indeed, as expectations of the relevant publics change, the corporation must make changes or the legitimacy gap will grow as the level of conflict increases and the level of positive and passive support decreases. The ‘legitimacy gap’ (used in the above quote) refers to the difference between the expectations of the ‘relevant publics’ relating to how an organisation should act, and society’s perceptions of how the organisation does act. Legitimacy Theory (and Stakeholder Theory) explicitly considers the organisation in its broader social context. Unlike PAT, Legitimacy Theory does not rely upon the economics-based assumption that all action is driven by individual self-interest (tied to wealth maximisation), and it emphasises how the organisation is part of the social system in which it operates. A number of studies, five of which are described briefly below (relevant studies will be discussed more fully in Chapter 32), have identified specific types of social-responsibility disclosures that have appeared within annual reports and that have been explained by the respective researchers as being part of the portfolio of strategies undertaken by accountants and their managers to bring legitimacy to, or to maintain the legitimacy of, their respective organisations. Patten (1992) focused on the change in the extent of environmental disclosures made by North American oil companies, other than Exxon Oil Company, both before and after the Exxon Valdez disaster in Alaska in 1989. He argued that if the Alaskan oil spill resulted in a threat to the legitimacy of the petroleum industry, and not just to Exxon, Legitimacy Theory would suggest that companies operating within that industry would respond by increasing the amount of voluntary environmental disclosures in their annual reports. Patten’s results indicate that there were increased environmental disclosures by petroleum companies for the post-1989 period, consistent with a legitimation perspective. This disclosure reaction took place across the industry, even though the incident itself concerned primarily one oil company. Patten (1992, p. 475) argued that ‘it appears that at least for environmental disclosures, threats to a firm’s legitimacy do entice the firm to include more social responsibility information in its annual report’. In an Australian study, Deegan and Rankin (1996) used Legitimacy Theory in an attempt to explain systematic changes in environmental disclosure policies in corporate annual reports around the time of proven environmental prosecutions. The authors examined the environmental disclosure practices of a sample of firms that were successfully prosecuted by the New South Wales and Victorian Environmental Protection Authorities (EPAs) for breaches of environmental protection laws during the period 1990 to 1993. (Any prosecutions by these agencies are reported in the EPAs’ annual reports, which are publicly available.) The annual reports of a final sample of 20 firms—prosecuted a total of 78 times—were reviewed to ascertain the extent of the environmental disclosures being made. These annual reports were matched by industry and size to the annual reports of a control group of 20 firms that had not been prosecuted. Of the 20 prosecuted firms, 18 provided environmental information in their annual report. However, the disclosures were predominantly self-laudatory and qualitative in nature. Only two organisations made any mention of the prosecutions. Deegan and Rankin found that prosecuted firms disclosed significantly more environmental information in the year of prosecution than any other year in the sample period. Consistent with the view that companies increase disclosures to offset any effects of EPA prosecutions, the EPA-prosecuted firms also disclosed more ‘favourable’ environmental information, relative to non-prosecuted firms. The authors conclude that the public disclosure of proven environmental prosecutions has an impact on the disclosure policies of the firms involved. Changes in disclosure practices are considered to represent a strategy to alter the public’s perception of the legitimacy of the organisation and this might be particularly important when the organisation has received negative publicity about certain aspects of its performance. In a United States study, the choice of an accounting framework was deemed to be related to a desire to increase the legitimacy of an organisation. Carpenter and Feroz (1992) argue that the decision of the government of the State of New York to adopt generally accepted accounting procedures (as opposed to a method of accounting based on cash flows rather than accruals) was ‘an attempt to regain legitimacy for the State’s financial management practices’ (p. 613). According to Carpenter and Feroz, New York State was in a financial crisis in 1975, with the result that many parties began to question the adequacy of the financial reporting practices of all the associated government units. To regain legitimacy, the state elected to implement GAAP (incorporating accrual-based accounting). According to Carpenter and Feroz (pp. 635, 637): The state of New York needed a symbol of legitimacy to demonstrate to the public and the credit markets that the state’s finances were well managed. GAAP, as an institutionalized legitimated practice, serves this purpose . . . We argue that New York’s decision to adopt GAAP was an attempt to regain legitimacy for the state’s financial Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 135 10/24/19 12:47 PM 136 PART 2: Theories of accounting management practices. Challenges to the state’s financial management practices, led by the state comptroller, contributed to confusion and concern in the municipal securities market. The confusion resulted in a lowered credit rating. To restore the credit rating, a symbol of legitimacy in financial management practices was needed. It is debatable whether GAAP was the solution for the state’s financial management problems. Indeed, there is strong evidence that GAAP did not solve the state’s financial management problems. New York needed a symbol of legitimacy that could be easily recognised by the public. In the realm of financial reporting, ‘GAAP’ is the recognized symbol of legitimacy. (Reprinted from CARPENTER, V. & FEROZ, E., 2001, ‘Institutional Theory and Accounting Rule Choice: An Analysis of Four US State Governments’ Decision to Adopt Generally Accepted Accounting Principles’, Accounting, Organizations and Society, vol. 26, with permission from Elsevier). According to Carpenter and Feroz, few would be likely to oppose a system that is ‘generally accepted’—general acceptance provides an impression of legitimacy. As they state (p. 632): Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. In discussing whether to use the term ‘GAAP’ instead of ‘accrual’ in promoting the accounting conversion efforts, panel members argued that no one could oppose a system that is generally accepted. The name implies that any other accounting principles are not accepted in the accounting profession. GAAP is also seemingly apolitical. (CARPENTER, V. & FEROZ, E., (2001), with permission from Elsevier). Within the context of companies that source their products from developing countries, Islam and Deegan (2010) undertook a review of the social and environmental disclosure practices of two leading multinational sportswear and clothing companies, these being Nike and Hennes & Mauritz. Islam and Deegan found a direct relationship between the extent of global news media coverage of a critical nature being given to particular social issues relating to the industry, and the extent of social disclosure. In particular, they found that once the news media started running a campaign that exposed poor working conditions and the use of child labour in developing countries, it appeared that the multinational companies responded by making various disclosures identifying initiatives that were being undertaken to ensure that the companies did not source their products from factories that had abusive or unsafe working conditions, or used child labour. Islam and Deegan argued that the evidence was consistent with the view that the news media influenced the expectations of Western consumers, thereby causing a legitimacy problem for the companies. The companies then responded to the legitimacy crisis by providing disclosures within their annual report that focused particularly on working conditions and the use of child labour in developing countries. Islam and Deegan showed that before the news media started running stories about the labour conditions in developing countries (media attention to these issues appeared to start in the early 1990s), the companies were in general not making such disclosures. This was despite the fact that evidence suggests that poor working conditions and the use of child labour existed in developing countries for many years before the newspapers started covering these issues. Islam and Deegan speculated that had the Western news media not run stories exposing the working conditions in developing countries—which created a legitimacy gap for the multinational companies—then the multinational companies might not have embraced initiatives to improve working conditions, nor provided disclosures about the initiatives being undertaken in relation to working conditions in developing countries. In related research, Deegan and Islam (2014) show how various social and environmental interest groups (NGOs) use contacts within the news media as part of their strategy to bring particular social and environmental issues to the attention of the community, thereby hoping to create some change in the social and environmental practices applied by organisations. WHY DO I NEED TO KNOW ABOUT THE INSIGHTS PROVIDED BY LEGITIMACY THEORY? Legitimacy Theory is a theory that has been used to explain voluntary reporting, particularly the voluntary reporting by organisations of social and environmental information. What the application of the theory has shown is that managers frequently make disclosures to portray a view that their activities are conforming with community expectations. Also, the evidence shows that managers often respond to crises by reporting information to help maintain, or restore, the legitimacy of an organisation. As such, application of the theory seems to support the view that managers make certain disclosures for survival reasons and not necessarily because of a belief that they owe some level of accountability to stakeholders. This is an important insight. Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 136 10/24/19 12:47 PM Chapter 3: Theories of financial accounting 137 Worked Example 3.6 applies Legitimacy Theory to explain why managers might make particular disclosures. WORKED EXAMPLE 3.6: Explaining organisational disclosures from a Legitimacy Theory perspective Following major crises or events of a social or environmental nature, organisations often respond by making a range of public disclosures in media such as annual reports or sustainability reports. REQUIRED From a Legitimacy Theory perspective, why would managers make such disclosures? SOLUTION Legitimacy Theory would suggest that disclosures will be made to bring legitimacy to an organisation. This is particularly important when it appears that the legitimacy of an organisation has potentially been eroded. As such, corporate disclosures are seen more as a strategy for corporate survival than as a mechanism for demonstrating accountability. Apart from Stakeholder Theory and Legitimacy Theory, another theory that embraces a systems-oriented perspective and which can be applied to analyse corporate reporting decisions is Institutional Theory. This theory, which we discuss next, explains that organisations are subject to institutional pressures and as a result of these pressures, organisations within a given environment often tend to become similar in their forms and practices. 3.13 Institutional Theory LO 3.13 Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. Broadly speaking, Institutional Theory considers the forms organisations take and provides explanations for why organisations within particular ‘organisational fields’ tend to take on similar characteristics and forms. DiMaggio and Powell (1983, p. 147) define an ‘organisational field’ as ‘those organizations that, in the aggregate, constitute a recognized area of institutional life: key suppliers, resource and product Institutional Theory consumers, regulatory agencies, and other organizations that produce similar services or products’. Theory that considers the forms organisations According to Carpenter and Feroz (2001, p. 565): Institutional theory views organizations as operating within a social framework of norms, values, and taken-for-granted assumptions about what constitutes appropriate or acceptable economic behaviour (Oliver, 1997). According to Scott (1987), ‘organizations, conform [to institutional pressures for change] because they are rewarded for doing so through increased legitimacy, resources, and survival capabilities’ (p. 498). (CARPENTER, V. & FEROZ, E., (2001), with permission from Elsevier). assume and explains why organisations within particular ‘organisational fields’ tend to take on similar characteristics and forms. A major paper in the development of Institutional Theory was DiMaggio and Powell (1983). They investigated why there was such a high degree of similarity between organisations. Specifically, in undertaking their research they asked (p. 148): why there is such startling homogeneity of organizational forms and practices; and [sought] to explain homogeneity, not variation. In the initial stages of their life cycle, organizational fields display considerable diversity in approach and form. Once a field becomes well established, however, there is an inexorable push towards homogenization. According to DiMaggio and Powell, there are various forces operating within society that cause organisational forms to become similar. As they state (1983, p. 148): Once disparate organizations in the same line of businesses are structured into an actual field (as we shall argue, by competition, the state, or the professions), powerful forces emerge that lead them to become more similar to one another. Dillard, Rigsby and Goodman (2004, p. 506) state that: Institutional theory is becoming one of the dominant theoretical perspectives in organization theory and is increasingly being applied in accounting research to study the practice of accounting in organizations. A key reason why Institutional Theory is relevant to researchers who investigate voluntary corporate reporting practices is that it provides a complementary perspective, to both Stakeholder Theory and Legitimacy Theory, for understanding how organisations interpret and respond to changing social and institutional pressures and expectations. Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 137 10/24/19 12:47 PM 138 PART 2: Theories of accounting Institutional Theory links organisational practices (such as accounting and corporate reporting) to, among other things, the values of the society in which the organisation operates and the need to maintain organisational legitimacy. The view is held that organisational form and practices might tend to some form of homogeneity—that is, the structure of the organisation and the practices adopted by different organisations tend to become similar to conform with what is considered to be ‘normal’ or ‘legitimate’. Organisations that deviate from the form that has become ‘normal’ or expected within certain institutional contexts will potentially have problems gaining or retaining legitimacy. As Dillard, Rigsby and Goodman (2004, p. 509) state: By designing a formal structure that adheres to the norms and behaviour expectations in the extant environment, an organization demonstrates that it is acting on collectively valued purposes in a proper and adequate manner. Institutional Theory provides an explanation for how mechanisms by which organisations might seek to align perceptions of their practices and characteristics with social and cultural values (in order to gain or retain legitimacy) become institutionalised in particular organisations. Such mechanisms might include those proposed by both Stakeholder Theory and Legitimacy Theory, but might conceivably encompass an even broader range of legitimating mechanisms. This is why these three theoretical perspectives (Legitimacy Theory, Stakeholder Theory and Institutional Theory) should be seen as complementary rather than competing. There are two main dimensions to Institutional Theory that are particularly relevant to our discussion of reporting. The first of these is termed isomorphism and the second decoupling. Both can be of central relevance to explaining voluntary corporate reporting practices. The term ‘isomorphism’ is used extensively within Institutional Theory and is defined by DiMaggio and Powell (1983, p. 149) as ‘a constraining process that forces one unit in a population to resemble other units that face the same set of environmental conditions’. That is, organisations that adopt structures or processes (such as reporting processes) at variance with other organisations might find that such differences will attract criticism. As Carpenter and Feroz (2001, p. 566) state: Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. DiMaggio and Powell (1983) label the process by which organizations tend to adopt the same structures and practices isomorphism, which they describe as a homogenization of organizations. Isomorphism is a process that causes one unit in a population to resemble other units in the population that face the same set of environmental conditions. Because of isomorphic processes, organizations will become increasingly homogeneous within given domains and conform to expectations of the wider institutional environment. (CARPENTER, V. & FEROZ, E., (2001), with permission from Elsevier). Dillard, Rigsby and Goodman (2004, p. 509) explain that ‘isomorphism refers to the adaptation of an institutional practice by an organization’. As voluntary corporate reporting by an organisation is an institutional practice of that reporting organisation, the processes by which voluntary corporate reporting adapts and changes in that organisation are isomorphic processes. DiMaggio and Powell (1983) set out three different isomorphic processes (processes whereby institutional practices such as voluntary corporate reporting adapt and change). These three isomorphic processes are referred to as coercive isomorphism, mimetic isomorphism and normative isomorphism. The first of these isomorphic processes, coercive isomorphism, arises when organisations change their institutional practices in response to pressure from stakeholders upon whom the organisation is dependent (in other words, this form of isomorphism is related to ‘power’ and therefore has similar traits to Stakeholder Theory, as discussed earlier in this chapter). According to DiMaggio and Powell (1983, p. 150): Coercive isomorphism results from both formal and informal pressures exerted on organizations by other organizations upon which they are dependent and by cultural expectations in the society within which organizations function. Such pressures may be felt as force, as persuasive, or as invitations to join in collusion. DiMaggio and Powell go on to advance the following two hypotheses on coercive isomorphism: Hypothesis 1: The greater the dependence of an organization on another organization, the more similar it will become to that organization in structure, climate, and behavioural focus. Hypothesis 2: The greater the centralization of organization A’s resource supply, the greater the extent to which organization A will change isomorphically to resemble the organizations on which it depends for resources. The above form of isomorphism is clearly related to the managerial branch of Stakeholder Theory (discussed earlier) whereby a company will use ‘voluntary’ corporate reporting disclosures to address the economic, social, environmental and ethical values and concerns of stakeholders who have the greatest power over the company. Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 138 10/24/19 12:47 PM Chapter 3: Theories of financial accounting 139 The company is therefore coerced (in this case usually informally) by its influential (or powerful) stakeholders into adopting particular voluntary reporting practices. With regard to applying coercive isomorphism to government’s selection of accounting procedures, Carpenter and Feroz (2001, p. 571) state: Other organizations that can provide resources, such as the credit markets, can exercise power over government entities. This power can be used to dictate the use of certain institutional rules—such as GAAP. (CARPENTER, V. & FEROZ, E., (2001), with permission from Elsevier). Explaining this more directly in terms of the earlier definition of isomorphism, the company is coerced into adapting its existing voluntary corporate reporting practices (including the issues upon which it reports) to bring these into line with the expectations and demands of its powerful stakeholders (while possibly ignoring the expectations of less powerful stakeholders). Because powerful stakeholders might have similar expectations to those of other organisations, there will tend to be conformity in the practices being adopted by different organisations—institutional practices will tend to some form of uniformity. The second isomorphic process specified by DiMaggio and Powell (1983) is mimetic isomorphism. This involves organisations seeking to emulate (perhaps copy) or improve upon the institutional practices of other organisations, often for reasons of competitive advantage in terms of legitimacy. In explaining mimetic isomorphism, DiMaggio and Powell (1983, p. 151) state: Uncertainty is a powerful force that encourages imitation. When organizational technologies are poorly understood, when goals are ambiguous, or when the environment creates symbolic uncertainty, organizations may model themselves on other organizations. Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. According to DiMaggio and Powell, when an organisation encounters uncertainty it might elect to model itself on other organisations operating within the institutional environment. The authors provide the following example of modelling (mimetic isomorphism) (1983, p. 151): One of the most dramatic instances of modelling was the effort of Japan’s modernizers in the late nineteenth century to model new governmental initiatives on apparently successful western prototypes. Thus, the imperial government sent its officers to study the courts, Army, and police in France, the Navy and postal system in Great Britain, and banking and art education in the United States. American corporations are now returning the compliment by implementing (their perceptions of) Japanese models to cope with thorny productivity and personnel problems in their own firms. The rapid proliferation of quality circles and quality-of-work-life issues in American firms is, at least in part, an attempt to model Japanese and European successes. These developments also have a ritual aspect; companies adopt these ‘innovations’ to enhance their legitimacy, to demonstrate that they are at least trying to improve working conditions. DiMaggio and Powell go on to provide the following two hypotheses on mimetic isomorphism: Hypothesis 3: The more uncertain the relationship between means and ends the greater the extent to which an organization will model itself after organizations it perceives to be successful. Hypothesis 4: The more ambiguous the goals of an organization, the greater the extent to which the organization will model itself after organizations that it perceives to be successful. As Unerman and Bennett (2004) explain in the context of a study investigating stakeholder dialogue in corporate social reporting: Some institutional theory studies . . . have demonstrated a tendency for a number of organisations within a particular sector to adopt similar new policies and procedures as those adopted by other leading organisations in their sector. This process, referred to as ‘mimetic isomorphism’, is explained as being the result of attempts by managers of each organisation to maintain or enhance external stakeholders’ perceptions of the legitimacy of their organisation, because any organisation which failed (at a minimum) to follow innovative practices and procedures adopted by other organisations in the same sector would risk losing legitimacy in relation to the rest of the sector (Broadbent et al. 2001; Scott 1995). Drawing upon these observations, in the absence of any legislative intervention prescribing detailed mechanisms of debate, a key motivating force for many managers to introduce mechanisms allowing for greater equity in the determination of corporate responsibilities would therefore be their desire to maintain, or enhance, their own competitive advantage. They would strive to achieve this by implementing stakeholder dialogue mechanisms which their economically powerful stakeholders were likely to perceive as more effective than those used by their competitors. It is unlikely that these managers would readily embrace mechanisms designed to Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 139 10/24/19 12:47 PM 140 PART 2: Theories of accounting facilitate widespread participation in the determination of corporate responsibilities unless their economically powerful stakeholders expected the interests of economically marginalized stakeholders to be taken into account in this manner, and these managers are only likely to implement the minimum procedures which they feel their economically powerful stakeholders would consider acceptable. (Reprinted from UNERMAN, J. & BENNETT, M., 2004, ‘Increased Stakeholder Dialogue and the Internet: Towards Greater Corporate Accountability or Reinforcing Capitalist Hegemony?’, Accounting, Organizations and Society, 29 (7), with permission from Elsevier). This argument links pressures for mimetic isomorphism with pressures underlying coercive isomorphism. As Unerman and Bennett (2004) maintain, without coercive pressure from stakeholders, pressure to mimic or surpass the social reporting practices (institutional practices) of other companies would be unlikely. The final isomorphic process explained by DiMaggio and Powell (1983) is normative isomorphism. This relates to the pressures arising from group norms to adopt particular institutional practices. In the case of corporate reporting, the professional expectation that accountants will comply with accounting standards acts as a form of normative isomorphism for the organisations for whom accountants work to produce accounting reports (an institutional practice) that are shaped by accounting standards. In terms of voluntary reporting practices, normative isomorphic pressures could arise through less formal group influences from a range of both formal and informal groups to which managers belong, for example, the culture and working practices developed within their workplace. These could produce collective managerial views favouring or rejecting certain types of reporting practices, such as collective managerial views on the desirability or necessity of providing a range of stakeholders with social and environmental information through the medium of corporate reports. DiMaggio and Powell provide the following two hypotheses on normative isomorphism: Hypothesis 5: The greater the reliance on academic credentials in choosing managerial and staff personnel, the greater the extent to which an organization will become like other organizations in its field. Hypothesis 6: The greater the participation of organizational managers in trade and professional associations, the more likely the organization will be, or will become, like other organizations in its field. Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. Now that the three forms of isomorphism have been described (coercive, mimetic and normative isomorphism), it is interesting to note that such processes do not necessarily make organisations more efficient. As DiMaggio and Powell (1983, p. 153) put it: It is important to note that each of the institutional isomorphic processes can be expected to proceed in the absence of evidence that they increase internal organizational efficiency. To the extent that organizational effectiveness is enhanced, the reason will often be that organizations are rewarded for being similar to other organizations in their fields. This similarity can make it easier for organizations to transact with other organizations, to attract careerminded staff, to be acknowledged as legitimate and reputable, and to fit into administrative categories that define eligibility for public and private grants and contracts. None of this, however, ensures that conformist organizations do what they do more efficiently than do their more deviant peers. On the same point, Carpenter and Feroz (2001, p. 569) observe: Institutional theory assumes that organizations adopt structures and management practices that are considered legitimate by other organizations in their fields, regardless of their actual usefulness. Legitimated structures or practices can be transmitted to organizations in a field through tradition (organization imprinting at founding), through initiation, by coercion, and through normative pressures . . . Institutional theory is based on the premise that organizations respond to pressure from their institutional environments and adopt structures and/or procedures that are socially accepted as being the appropriate organizational choice . . . Institutional techniques are not based on efficiency but are used to establish an organization as appropriate, rational, and modern . . . By designing a formal structure that adheres to the prescription of myths in the institutional environment, an organization demonstrates that it is acting in a proper and adequate manner. Meyer and Ronan (1977) maintain that myths of generally accepted procedures—such as GAAP—provide a defence against the perception of irrationality and enhanced continued moral and/or financial support from external resource providers. (CARPENTER, V. & FEROZ, E., (2001), with permission from Elsevier). While three distinct types of isomorphism have been described here, in practice it will not necessarily be easy to differentiate between them. As Carpenter and Feroz (2001, p. 573) state: DiMaggio and Powell (1983) point out that it may not always be possible to distinguish between the three forms of isomorphic pressure, and in fact, two or more isomorphic pressures may be operating simultaneously making it Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 140 10/24/19 12:47 PM Chapter 3: Theories of financial accounting 141 nearly impossible to determine which form of institutional pressure was more potent in all cases. (CARPENTER, V. & FEROZ, E., (2001), with permission from Elsevier). In applying the various notions of isomorphism to accounting, the decision to disclose particular items of information may be more about ‘show’ than about ‘substance’. As Carpenter and Feroz (2001, p. 570) state: One manifestation of organizations in need of institutional legitimacy is the collecting and displaying of huge amounts of information that has no immediate relevance for actual decisions. Hence those state governments that have adopted GAAP, yet do not use GAAP information in making financial management decisions (e.g. budgetary decisions), may have adopted GAAP for purposes of institutional legitimacy. (CARPENTER, V. & FEROZ, E., (2001), with permission from Elsevier). Carpenter and Feroz (2001) used Institutional Theory to explain four US state governments’ decisions to switch from a method of accounting based on recording cash flows to methods of accounting based on generally accepted accounting principles (GAAP). In describing the results of their analysis, they state (p. 588): Our evidence shows that an early decision to adopt GAAP can be understood in terms of coercive isomorphic pressures from credit markets, while late adopters seem to be associated with the combined influences of normative and mimetic institutional pressures . . . The evidence presented in the case studies suggests that severe, prolonged financial stress may be an important condition affecting the potency of isomorphic pressures leading to an early decision to adopt GAAP for external financial reporting. Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. They went on to conclude (p. 592): All states were subject to normative isomorphic pressures from the accounting profession, coercive isomorphic pressures from the credit markets, and from the federal government to adopt GAAP from 1975 through 1984. Coercive isomorphic institutional pressures were significantly increased in 1984 with the passage of the Single Audit Act (SAA). And the formation of the Government Accounting Standards Board (GASB). Since it is likely that both normative and coercive isomorphic pressures act in concert to move state governments to GAAP adoption, it may be impossible to empirically distinguish the two forms of isomorphic pressure . . . We note that all state governments were subject to potent institutional pressure to adopt GAAP after 1973. These institutional pressures were created by the federal government, professional accounting associations, and representatives of the credit markets. Thus state governments were subjected to at least two forms of isomorphic pressures: normative and coercive . . . We predict that all state governments in the USA will eventually bow to institutional pressures for change and adopt GAAP for external financial reporting. Our prediction is based on insights from institutional theory, coupled with insight on the potency of the institutional pressures for change identified in our four case studies. (CARPENTER, V. & FEROZ, E., (2001), with permission from Elsevier). Turning to the other dimension of Institutional Theory, decoupling implies that while managers might perceive a need for their organisation to be seen to be adopting certain institutional practices, and might even institute formal processes aimed at implementing these practices, actual organisational practices can be very different from these formally sanctioned and publicly pronounced processes and practices. Thus, the actual practices can be decoupled from the institutionalised (apparent) practices. In terms of voluntary corporate-reporting practices, this decoupling can be linked to some of the insights from Legitimacy Theory whereby social and environmental disclosures can be used to construct an organisational image that is very different from actual organisational, social and environmental performance. Thus, the organisational image constructed through corporate reports might be one of social and environmental responsibility when the actual managerial imperative is maximisation of profitability or shareholder value. As Dillard, Rigsby and Goodman (2004, p. 510) put it: Decoupling refers to the situation in which the formal organizational structure or practice is separate and distinct from actual organizational practice. In other words, the practice is not integrated into the organization’s managerial and operational processes. Formal structure has much more to do with the presentation of an organizational-self than with the actual operations of the organization (Curruthers, 1996). Ideally, organizations pursue economic efficiency and attempt to develop alignment between organizational hierarchies and activities. However, an organization in a highly institutionalized environment may face conflicts and inconsistencies between the demands for efficiency and the need to conform to ‘ceremonial rules and myths’ of the institutional context (Meyer & Rowan, 1977). In essence, institutionalized, rationalized elements are incorporated into the organization’s formal management systems because they maintain appearances and thus confer legitimacy whether or not they directly facilitate economic efficiency. Insights about ‘decoupling’ are particularly relevant for people who read corporate reports (such as investors, lenders, regulators, researchers and other stakeholders) as they provide a warning not to believe that public disclosures made Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 141 10/24/19 12:47 PM 142 PART 2: Theories of accounting by organisations necessarily always reflect what is occurring within them. For example, just because an organisation publicly discloses various missions, values and policies which seem to indicate that the managers adopt the best available environmental or social practices, this does not necessarily mean this is how the organisation actually operates. As such, there is an overlap with insights provided by Legitimacy Theory, Stakeholder Theory and Positive Accounting Theory. While Institutional Theory has been applied to explain why organisational structures and processes might take on similar forms, it has also been applied by some researchers to explain why particular processes might not work, or be applicable, within particular institutional settings. For example, governance policies or reporting practices that might work or be expected to be in place within a developed country context might not be appropriate within a developing country context. That is, we learn from Institutional Theory that there is a need when implementing particular reporting (and other) processes to consider the broader institutional context of each organisation (see, for instance, Tilt 2016, 2018). For example, greater consideration of the normative, cultural/cognitive and regulative influences in place within different social/institutional contexts, and how these different contexts then influence the propensity of managers to make (potentially legitimising) social and environmental disclosures, is warranted before it is suggested that particular policies that ‘work’ in one context should be applied in another. As Tilt (2016, 2018) discusses, expecting particular reporting guidance, regulations or approaches that have been developed within a developed country context (with particular regulative, cultural/cognitive and normative influences) to work, or be embraced, within both a developed country context and a developing country context is rather naive. There can be different institutional pressures in the different contexts and this influences which practices the organisation will adopt—including reporting practices—and how those practices will be perceived by stakeholders within those institutional contexts. As institutional contexts change, the acceptance of, and motivations for, particular disclosure approaches also likely change. Tilt (2016, 2018) specifically notes the need to recognise how contextual factors such as the level of economic development, extent of civil liberties, national focus on economic growth versus sustainability, level and type of government control, religion, government ideology, media freedom and prevailing language might impact the propensity to which managers elect to report various forms of social and environmental performance information. Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. WHY DO I NEED TO KNOW ABOUT THE INSIGHTS PROVIDED BY INSTITUTIONAL THEORY? Institutional Theory emphasises that the way organisations are structured and the way they operate is greatly influenced by the institutional environments in which they operate. Knowledge of this theory will emphasise to us that policies and procedures which are appropriate or legitimate in some institutional environments will not be appropriate or legitimate in others. This theory therefore provides important insights that enable us to understand why we should not expect certain policies—including reporting and auditing practices—to be appropriate in different industries, countries or cultures. The theory is also useful as it highlights that while certain structures might appear to be in place within an organisation in order to bring legitimacy, there might actually be a decoupling or disconnection between the apparent existence of such policies and procedures and the actual activities of the organisation. Worked Example 3.7 applies Institutional Theory to explain why particular organisational practices might work in some institutional contexts but not others. WORKED EXAMPLE 3.7: The application of Institutional Theory It is often suggested that particular practices—such as specific reporting practices or occupational health and safety practices—that are applied in economically developed countries can be ‘exported’ and applied successfully within the context of developing countries. REQUIRED From an Institutional Theory perspective, is it always sensible to expect something that works in a developed country context to also work within a developing country context? SOLUTION No, it is not sensible. A developing country context will have a different regulatory environment (which might allow a high degree of non-compliance with the law), a different culture and a different perspective of professional conduct. To expect the rules and regulations that work in a developed country context to also work when exported to a different institutional environment is naive. Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 142 10/24/19 12:47 PM Chapter 3: Theories of financial accounting 143 Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. From the material provided in this chapter, it can be seen that PAT, Stakeholder Theory, Legitimacy Theory and Institutional Theory all provide different (but sometimes overlapping) theoretical perspectives on why organisations might elect to make (or not make) particular disclosures. The relevance of such theories would arguably be greater where there is no regulation prescribing how organisations are to account for a particular transaction or event, or how to disclose particular information. In such a case, particular motivations, and not regulation, might drive what disclosures are made and what accounting methods are adopted. The various theories described above are summarised in Table 3.1. Theory Type Description Positive Accounting Theory (PAT) Positive Seeks to explain and predict particular phenomena, especially the managers’ choice of accounting methods. Grounded in classical economics, it focuses on relationships between various individuals within and outside an organisation and explains how financial accounting can be used to minimise the cost implications of each contracting party operating in its own self-interest. Current-cost accounting Normative Aims to provide a prescription for a calculation of income that, after adjustments are made for changing prices, could be withdrawn from the entity while leaving its physical capital intact. The maintenance of the firm’s physical capital or operating capacity is central to current-cost accounting. Exit-price accounting (CoCoA) Normative The central objective of CoCoA is to provide information about an entity’s ‘capacity to adapt’ to changing circumstances, with profit being directly related to changes in adaptive capacity. Profit is calculated as the amount that can be distributed while maintaining the entity’s adaptive capital intact. Deprival-value accounting Normative Can be defined as the value to the business of particular assets. Deprival-value accounting provides the basis for how assets should be measured. 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 generated by the asset. Stakeholder Theory Managerial (Positive) branch Seeks to explain and predict how an organisation will react to the demands of various stakeholders. It predicts that organisations will tend to satisfy the information needs of those stakeholders who are important to the organisation’s ongoing survival. Whether a particular stakeholder receives information will depend on how powerful that stakeholder is perceived to be—power often being considered in terms of the scarcity and importance of the resources controlled by the stakeholder concerned. Ethical (Normative) branch All stakeholders have intrinsic rights that should not be violated. Stakeholders have rights to information that should be met regardless of the power of the stakeholders involved. Disclosures are considered to be responsibility driven. Legitimacy Theory Positive Often utilises the notion of a social contract, which is an implied contract representing the norms and expectations of the community in which the organisation operates. An organisation is deemed to be legitimate to the extent that it complies with the terms of the social contract. Legitimacy Theory predicts that the organisation will make information disclosures to gain, maintain or restore its legitimacy (and thereby its ability to continue operating). Institutional Theory Managerial/ Positive Provides a complementary perspective to Stakeholder Theory and Legitimacy Theory. It provides a framework for understanding how organisations interpret and respond to changing social and institutional pressures. There are two frequently applied dimensions to Institutional Theory—namely, isomorphism and decoupling. Isomorphism is related to the managerial branch of Stakeholder Theory, while decoupling tends to be more linked to some of the insights of Legitimacy Theory. Table 3.1 Summary of theories described so far within this chapter Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 143 10/24/19 12:47 PM 144 PART 2: Theories of accounting While there are numerous theories that can be applied to explain managers’ choice of accounting methods or disclosure strategies (particularly where there are no legislative requirements), there are also a number of theories that have been constructed to explain how and why accounting regulation is developed (including theories explaining the introduction of regulation). As with the other theories discussed in this chapter, there is no one generally accepted theory of regulation. In fact, there is much debate about what drives the introduction of regulation. The following discussion will briefly consider some of this debate. LO 3.14 3.14 Theories that seek to explain why regulation is introduced As indicated in Chapter 1, general purpose financial reporting—which is the focus of this book—is subject to a great deal of regulation. For example, listed companies must comply with a multitude of accounting standards, as well as with the corporations legislation and securities exchange listing requirements. In this section, a brief overview is provided of some of the theories developed to explain why regulation is introduced. Arguments in favour of or against regulation (that is, the pro-regulation versus free-market arguments) will not be considered here, as they were briefly considered in Chapter 1. In the material that follows, you will see that different researchers have advanced different arguments about what causes regulation to be introduced. Some theories of regulation suggest that regulation is introduced in the public interest, while other theories suggest that regulation is introduced to benefit some people or stakeholders at the expense of others, that is, in self-interest. Public Interest Theory Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. According to Posner (1974, p. 335), Public Interest Theory ‘holds that regulation is supplied in response to the demand of the public for the correction of inefficient or inequitable market practices’. That is, regulation is initially put in place to benefit society as a whole, rather than to benefit particular vested interests, and the regulatory body is considered to represent the interests of the society in which it operates, rather than the private interests of the regulators. The enactment of legislation is considered to be a balancing act between the social benefits and the social costs of the regulation. The application of this argument to financial accounting, given the existence of a capitalist economy, implies that society needs confidence in the capital markets to help ensure that resources are directed towards productive assets. Regulation is deemed to be an instrument for creating such confidence. There are many people who are critical of this fairly simplistic perspective of why regulation is introduced (for example, Stigler 1971; Posner 1974; and Peltzman 1976). Posner (1974, p. 337) states: [There is] a good deal of evidence that the socially undesirable results of regulation are frequently desired by groups influential in the enactment of the legislation setting up the regulatory scheme . . . Sometimes the regulatory statute itself reveals an unmistakable purpose of altering the operation of markets in directions inexplicable on public interest grounds. Proponents of the economics-based assumption of self-interest would argue against accepting that any legislation was put in place by particular parties because these parties genuinely believe it to be in the public interest. Rather, they consider that legislators will enact legislation only because it might increase their own wealth (perhaps through increasing their likelihood of being re-elected), and people will lobby for particular legislation only if it is in their own interests. Obviously, as with most theoretical assumptions, this (simplistic) self-interest assumption is one that (hopefully!) will not always hold. Nevertheless, and as is shown in this chapter, the belief that ‘self-interest drives all’ is central to many theoretical perspectives. Capture Theory Researchers who embrace Capture Theory (capture theorists) would typically argue that although regulation might be introduced with the aim of protecting the ‘public interest’ (as argued in Public Interest Theory, as briefly described above), this laudable aim of protecting the public interest will not ultimately be achieved, because in the process of introducing regulation the organisations that are subject to the regulation will ultimately come to control the regulator. The regulated industries will seek to gain control of the regulatory body, because they will know that the decisions made by the regulator will potentially have significant impacts on their industry. The regulated parties or industries will seek to take charge of (capture) the regulator with the intention of ensuring that the regulations subsequently released by the regulator (post-capture) will be advantageous to their industry. As an example of possible regulatory capture, we might consider the contents of a newspaper article entitled ‘Aviation industry “captured” safety body’ (Canberra Times, 4 July 2008), in which it was stated: Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 144 10/24/19 12:47 PM Chapter 3: Theories of financial accounting 145 A former senior legal counsel to the Civil Aviation Safety Authority for more than a decade has accused the regulator of failing as a safety watchdog because it is too close to the industry. Peter Ilyk, who left the authority in 2006, told a Senate inquiry into CASA’s administration and governance the authority had been ‘captured’ by the industry, making it reluctant to deal decisively with air operators who fell short of safety regulations . . . Another former staff member, Joseph Tully, who was policy manager general aviation before he left last year, agreed CASA was too close to the industry. ‘You have got to keep a professional distance when you’re a regulator . . . we have become more of a partner than a regulator in the last few years,’ Mr Tully said. As another possible example of industry capture, a newspaper article that appeared in The Australian on 17 July 2019 (by Michael Rodden, entitled ‘Overseas watchdogs can end “cosy” alliance’, p. 2) argued that senior representatives in the Australian Securities and Investments Commission (ASIC) became too close to the banking sector and as a result Australia’s corporate watchdog ‘too often failed to regulate the banking sector properly because they were captured by the industry’. The concerns were raised because many senior officers within ASIC were ultimately offered senior appointments within banking organisations, and therefore, knowing that banks would make such appointments, the senior ASIC officials were perceived to be less inclined to make tough decisions against the industry when acting as regulators, because to do so might mean they would be shunned from appointments on leaving ASIC. In another related article entitled ‘Bank boards are full of former regulators’, which appeared in The Australian Financial Review on 23 October 2018 (by John Kehoe, p. 8), it was reported that Graeme Samuel, former chairperson of the Australian Competition and Consumer Commission, stated that Australian economic regulators are ‘at risk of capture from the financial services industry because of the potential lure of working in a highly paid and powerful job at a big bank in their post-public service career’. It was also reported that Samuel was of the view that: there is a risk that regulatory personnel may pull their regulatory punches, knowing a future employer could be on the receiving end. Samuel said there was a danger of the ‘vulnerable regulator’—junior or senior— ‘feeling the need to be liked’ and wanting to feel they are ‘mixing it with the big end of town’. ‘The most serious risk for regulators is industry capture,’ said Samuel. ‘Industry is adept at implementing regulatory capture strategies.’ Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. Mitnick (1980, p. 95, as reproduced in Walker 1987, p. 281) provides a useful description of the Capture Theory perspective: Capture is said to occur if the regulated interest controls the regulation and the regulated agency; or if the regulated parties succeed in coordinating the regulatory body’s activities with their activities so that their private interest is satisfied; or if the regulated party somehow manages to neutralise or ensure non-performance (or mediocre performance) by the regulating body; or if in a subtle process of interaction with the regulators the regulated party succeeds (perhaps not even deliberately) in co-opting the regulators into seeing things from their own perspective and thus giving them the regulation they want; or if, quite independently of the formal or conscious desires of either the regulators or the regulated parties, the basic structure of the reward system leads neither venal nor incompetent regulators inevitably to a community of interests with the regulated party. As with many other industries, at various times and in various jurisdictions it has been argued that large accounting firms have captured the accounting standard-setting process. This was of such concern in the United States that in 1977 the United States Congress investigated whether the Big Eight accounting firms had ‘captured’ the standard-setting process (Metcalf Inquiry). In Australia, Walker (1987) provides an interesting analysis of the early existence of the Accounting Standards Review Board (subsequently replaced by the Australian Accounting Standards Board). Walker’s analysis is consistent with the perspective that the Accounting Standards Review Board (ASRB), a government body, was ‘captured’ by the accounting profession (using the definition of ‘capture’ provided above by Mitnick (1980)). Walker himself was a member of the ASRB from 1984 to 1985. In commenting on his motivation for documenting the case study of the ASRB, Walker states (p. 285) that: The main concern was to highlight the way that a set of standard-setting arrangements designed to permit widespread consultation and participation were subverted by some likeable, well-meaning individuals who were trying only to promote the interests of their fellow accountants. Chapter 1 discussed some changes that were made several years ago to the processes by which accounting standards are developed in Australia. This involved taking accounting standard-setting out of the hands of the profession and putting it under the control of a government body. As indicated then, the motivation for the changes seemed, at least Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 145 10/24/19 12:47 PM 146 PART 2: Theories of accounting in part, to be the view that the accounting profession played too great a part in developing standards that would be applied by the accounting profession. The profession appeared to have captured the regulatory process in relation to developing accounting standards. Proponents of Capture Theory typically argue that regulation is usually introduced, or regulatory bodies are established, to protect the public interest. This would seem to be the case in Australia with regard to the establishment of the Accounting Standards Review Board (the predecessor to the AASB). Before the establishment of the ASRB, accounting standards were issued by the accounting profession, and sanctions for non-compliance (which were very rarely imposed) could be imposed only against members of the profession. Walker (1987, p. 270) notes that throughout the 1970s (before the establishment of the ASRB in 1984), monitoring activities by government agencies revealed a high incidence of non-compliance with profession-sponsored accounting rules. It was argued that this non-compliance undermined public confidence in the capital market, and this reduction in public confidence was itself not deemed to be in the public interest. Government-sponsored standards, through the establishment of the ASRB, together with associated legal sanctions, should, it was thought, raise the level of compliance and hence the confidence of the public in company reporting practices. According to Walker (1987, p. 271): The accounting profession strongly opposed the ‘costly and possibly bureaucratic step’ of involving government in the preparation of accounting rules. It publicised counter-proposals that . . . legislative backing be extended to the profession’s own standards. The files of the Commonwealth Attorney-General’s Department relating to the establishment of the ASRB (copies of which were obtained in terms of Commonwealth Freedom of Information legislation) record that National Companies and Securities Commission Chairman Leigh Masel referred to a ‘concerted lobby by the accounting profession’ on these matters. According to Walker (1987), Masel telexed members of the Commonwealth government’s Ministerial Council advising that the NCSC (ultimately replaced by ASIC) had received submissions opposing the profession’s proposals. Part of the message stated: A particular concern expressed in discussions with some respondents was that, if the accounting profession’s proposals are accepted, the status and income of the profession would, effectively, be accorded statutory protection without any corresponding requirement for public reporting and accountability by that profession. For reasons readily apparent, there are many in the profession who would welcome the safe harbour which legislative recognition would provide. Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. By way of concluding remarks on the ASRB’s ‘capture’, Walker (1987, p. 282) states: During 1984–5 the profession had ensured the non-performance of the ASRB and by the beginning of 1986 the profession had managed to influence the procedures, the priorities and the output of the Board. It was controlling both the regulations and the regulatory agency; it had managed to achieve coordination of the ASRB’s activities; and it appears to have influenced new appointments so that virtually all members of the Board might reasonably be expected to have some community of interests with the professional associations. The ASRB had been ‘captured’ by the profession within only 24 months. Chand and White (2007) also consider the issue of regulatory capture. In doing so, they also explain government involvement in the accounting standard-setting process, and why, in the Australian context, the Financial Reporting Council was established to oversee the activities of the Australian Accounting Standards Board. Chand and White (2007, p. 612) state: Some jurisdictions, notably the US and Australia, have taken the regulatory process under the wing of a government agency, to efface or avoid its being captured by the profession. For example, the US has taken steps through the Sarbanes-Oxley legislation to strengthen the regulator’s independence (Herz, 2002; Schipper, 2003). Similarly, in Australia the new standard-setting arrangements were introduced in 1997, including the Financial Reporting Council to oversee the Australian Accounting Standards Board (Haswell and McKinnon, 2003, p. 10). Such remedial measures were seen as necessary in these countries, demonstrating that the regulatory process may have been captured. Economic Interest Group Theory of Regulation Another theory of regulation is the Economic Interest Group Theory of Regulation (or, as it is sometimes called, Private Interest Theory of Regulation), which assumes that groups will form to protect particular economic interests. Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 146 10/24/19 12:47 PM Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. Chapter 3: Theories of financial accounting 147 Different groups are viewed as often being in conflict with each other, and the different groups will lobby government to put in place legislation that economically benefits them (at the expense of others). For example, consumers might lobby government for price protection, or producers might lobby for tariff protection. This theoretical perspective adopts no notion of public interest—rather, private interests are considered to dominate the legislative process. As Posner (1974) states, ‘the economic theory of regulation is committed to the strong assumptions of economic theory generally, notably that people seek to advance their self-interest and do so rationally’. In relation to financial accounting, particular industry groups might lobby the regulator to accept or reject a particular accounting standard. For example, in Australia an accounting standard relating to the activities of general insurers was released in 1990 (AASB 1023 General Insurance Contracts). One requirement of this standard that was particularly unpopular with some insurance firms was that their investments had to be valued at net market value, with any changes therein to be taken directly to profit or loss. To a number of firms, this introduced unwanted volatility in earnings, which they felt would negatively affect their operations. They lobbied the Australian Accounting Standards Board to amend the requirement. Another example is the fact that many corporations lobbied the AASB to remove the former requirement that purchased goodwill be amortised to the income statement over a maximum period of 20 years (previously required in Australia by AASB 1013), the argument being that this affected their international competitiveness. The accounting standards relating to goodwill and general insurers were not amended to take account of these concerns. However, they were subsequently amended as a result of Australia’s decision to adopt IFRSs by 2005. If we accept the Economic Interest Group Theory of Regulation, the lack of initial success in this instance must have been due to the fact that a more powerful interest group favoured the alternative situation. Watts and Zimmerman (1978) reviewed the lobbying behaviour of United States corporations in relation to a proposal for the introduction of general price level accounting—a method of accounting that, in periods of inflation, would lead to a reduction in reported profits. The authors demonstrated that large, politically sensitive firms favoured the proposed method of accounting, since it led to reduced profits. This was counter to normal expectations that companies would generally prefer to show higher, rather than lower, earnings. It was explained on the (self-interest) basis that the larger firms would be viewed more favourably by various groups in the community if they reported lower profits. Reporting lower profits was less likely to have negative wealth implications for the organisations (perhaps in the form of government intervention, consumer boycotts or claims for higher wages). According to the Economic Interest Group Theory of Regulation, the regulator itself is also an interest group—a group that is motivated to embrace strategies to ensure re-election, or to ensure the maintenance of its position of power or privilege within the community. We should remember that regulatory bodies can be very powerful. The regulatory body, typically government controlled, possesses a resource (potential legislation) that can increase or decrease the wealth of various sectors of the constituency. In keeping with this perspective of regulation, rather than regulation being put in place initially in the public interest (as is initially assumed within Capture Theory and also in Public Interest Theory), it is proposed that regulation is put in place to serve the private interests of particular parties, including politicians who seek re-election. According to Posner (1974, p. 343), economic interest theories of regulation insist that economic regulation serves the private interests of politically effective groups. Further, in relation to the political process, Stigler (1971, p. 12) states: The industry which seeks regulation must be prepared to pay with the two things a party needs: votes and resources. The resources may be provided by campaign contributions, contributed services (the businessman heads a fundraising committee), and more indirect methods such as the employment of party workers. The votes in support of the measure are rallied, and the votes in opposition are dispersed, by expensive programs to educate (or uneducate) members of the industry and other concerned industries . . . The smallest industries are therefore effectively precluded from the political process unless they have some special advantage such as geographical concentration in a sparsely settled political subdivision. Under the Economic Interest Theory of Regulation, the regulation itself is considered to be a commodity, subject to the economic principles of supply and demand. According to Posner (1974, p. 344): Since the coercive power of government can be used to give valuable benefits to particular individuals or groups, economic regulation—the expression of that power in the economic sphere—can be viewed as a product whose allocation is governed by laws of supply and demand . . . There are a fair number of case studies—of trucking, airlines, railroads, and many other industries—that support the view that economic regulation is better explained as a product supplied to interest groups than as an expression of the social interest in efficiency or justice. Reflecting upon the above discussion, do you think that accounting standards are introduced in the public interest, or in the self-interest of particular groups? Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 147 10/24/19 12:47 PM 148 PART 2: Theories of accounting While our discussion of ‘theories of regulation’ (Public Interest Theory, Capture Theory and Economic Interest Group Theory) is brief and certainly does not include all theories pertaining to why regulation is introduced, the discussion does provide some insights into why particular regulations might have been established. Because accounting is subject to a great deal of regulation, it is often interesting to consider why particular regulations were introduced (and perhaps why some other proposed regulation was not ultimately introduced). The theories briefly described above provide some insights that may be helpful in answering such questions. WHY DO I NEED TO KNOW ABOUT THE INSIGHTS PROVIDED BY SOME OF THE THEORIES OF REGULATION? The practice of financial reporting—the focus of this book—is heavily regulated. Therefore, as students of accounting it is important that we understand some of the potential reasons why the regulation might have been introduced. As we learned, while regulation is often assumed to be in place for the ‘public interest’, this will not always be the case. We should be aware of this. Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. Lastly, it should be noted that in our discussion of theories we have not addressed another branch of theories that are often applied in the accounting literature, which are often referred to broadly as critical theories of accounting. Critical accounting theories involve a perspective that goes beyond questioning whether particular methods of accounting should be employed but instead focuses on the role of accounting—including financial accounting—in sustaining the privileged positions of those in control of particular resources (capital) while undermining or restraining the voice of those without capital. The view promoted by researchers operating within a critical theoretical perspective is that accounting, far from being a practice that provides a neutral or unbiased representation of underlying economic facts, actually provides the means of maintaining the powerful positions of some sectors of the community while suppressing the position and interests of those without wealth. Critical theorists explore how accounting potentially contributes to elements of society that are not equitable for some stakeholders, such as employees or particular communities. While quite fascinating, and in many respects very illuminating in highlighting inequities, the discussion of critical accounting theories is beyond the ambit of this book. Nevertheless, interested readers are encouraged to read further material on the topic (for example, see Chapter 12 in Deegan 2014, which is dedicated to the topic). SUMMARY This chapter has described various theories that can be applied to the practice of financial accounting. It is stressed that no single theory is universally accepted. A theory itself is defined as a coherent group of propositions used as an explanation for a class of phenomena. The phenomena studied in accounting theory obviously relate to the practice of accounting, but which phenomena are selected for study from the many available will depend on the theoretical approach that is adopted. The chapter has considered the differences between positive and normative theories of accounting. A positive theory of accounting is one that seeks to explain and predict particular accounting-related phenomena, whereas a normative theory of accounting prescribes how accounting should be practised. The Conceptual Framework for Financial Reporting, which was considered in some depth in Chapter 2 and revisited in other chapters throughout this book, is classified as a normative theory of accounting. One positive theory of accounting that we described in some detail was Positive Accounting Theory—a theory that was popularised by theorists such as Watts and Zimmerman. Researchers who adopt a Positive Accounting Theory perspective typically study issues such as the capital market’s reaction to particular accounting policies; what motivates managers to select one method of accounting from among competing alternatives; and the reasons for the existence of particular accounting-based contracts. Positive Accounting Theory proponents typically rely upon a fundamental assumption that individual action can be predicted on the basis that all action is driven by a desire to maximise wealth. As we have seen, such an assumption is often criticised by researchers who adopt alternative theoretical perspectives. Normative accounting theorists typically argue that it is a central role of accounting theory to provide prescription, that is, to inform others about the optimal accounting approach to adopt and why this particular approach is considered optimal. In this view, to fail to provide such prescription is to neglect one’s duties as an accounting academic. Normative theories that are considered briefly in this chapter include the Conceptual Framework, current-cost accounting, exit-price Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 148 10/24/19 12:47 PM Chapter 3: Theories of financial accounting 149 accounting and deprival-value accounting. Each of the normative theories of accounting differs from the others in its prescriptions, depending on the perspective adopted on how information is used by individuals and, linked to this, what information is actually important to inform decision making. This chapter also briefly considers systems-based theories. These theories, which include Stakeholder Theory, Legitimacy Theory and Institutional Theory, see the organisation as being firmly embedded within a broader social system. The organisation is considered to be affected by, and to affect, the society in which it operates. According to these theories, accounting disclosures are a way to manage relations with particular groups outside the organisation. In a sense, organisational activities and accounting disclosures are perceived to be reactive to community pressures. How the firm operates and what it reports will be influenced by a consideration of various stakeholder expectations. Because these ‘systems-based’ theories seek to explain and predict particular corporate actions they can also be considered to be ‘positive theories’ (as opposed to being ‘normative theories’). Apart from theories to explain or prescribe the selection of particular accounting methods, we also considered theories that seek to explain how regulation is developed, that is, we considered theories of regulation. We saw that some theories of regulation suggest that regulation is introduced to serve the public interest by regulators who work for the public good, whereas other theories of regulation assume that the development of regulation is driven by considerations of self-interest. This chapter has emphasised that the selection of one theory in preference to another will depend on the views and expectations of the researcher in question. We have seen that there is often heated debate between individuals from the alternative schools of thought. Theories, as abstractions of reality, cannot be expected to perfectly explain and predict all accounting-related phenomena, nor can they be expected to provide optimal solutions in all cases. No one theory of accounting can—or, perhaps, should—ever be definitively described as the best theory. If we accept this, we will see that different theoretical perspectives can, at various times, provide us with valuable insights into accounting issues. In the balance of this book, accounting requirements as stipulated by the different accounting standards will be considered. As appropriate, reference will be made to the theories discussed in this chapter, thus providing insight into the implications of the various accounting requirements and reporting practices that organisations adopt. Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. KEY TERMS accounting-based bonus scheme 108 accounting policy notes 120 agency relationship 104 bonus scheme 107 capacity to adapt 126 Continuously Contemporary Accounting (CoCoA) 126 creative accounting 120 current cash equivalents 127 current-cost accounting 126 current replacement cost 128 debt covenant 113 debtholder 113 exit-price theory 126 generally accepted accounting principles 108 information asymmetry 107 Institutional Theory 137 Legitimacy Theory 133 leverage (gearing) 113 monitoring cost 105 net present value 109 net selling price 128 normative accounting theories 124 perquisite consumption 106 political costs 114 Positive Accounting Theory (PAT) 104 present value 128 rational economic person assumption 106 social contract 133 social-responsibility disclosures 129 Stakeholder Theory 129 systems-oriented theories 128 theory 102 ANSWERS TO OPENING QUESTIONS At the beginning of this chapter we asked the following five questions. As a result of reading this chapter, you should now be able to provide informed answers to these questions—ours are shown below. 1. Can the practice of financial reporting be undertaken without knowledge of various theories that can be related to accounting? LO 3.1 Yes, we can prepare financial reports without knowing about various theories of accounting (although at a minimum we should know about the Conceptual Framework, which can be considered to be a normative theory of accounting). However, to understand various issues such as: why managers and their accountants might apply particular accounting practices; how particular stakeholders might react to particular disclosures; why particular stakeholders arguably have a right to particular information; or why regulators favour particular reporting requirements, we need theory to provide a framework to understand such questions. Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 149 10/24/19 12:47 PM 150 PART 2: Theories of accounting 2. Can the implications of various aspects of financial reporting be well understood in the absence of knowledge of related theories? LO 3.1 Arguably not. Various theories provide logical insights into the implications that result from managers making particular disclosure decisions. These theories are typically developed, tested and refined over many years. Without knowledge of these theories, our own insights about the practice of accounting would be limited. 3. What is the difference between a positive theory and a normative theory? LO 3.1 Generally speaking, a positive theory seeks to explain and/or predict certain phenomena (such as managers’ choice of accounting policies), whereas a normative theory prescribes what actions should be undertaken (for example, that managers should disclose particular information to stakeholders using specific reporting frameworks). 4. Is the IASB Conceptual Framework for Financial Reporting a normative or positive theory of accounting? Why? LO 3.9 The Conceptual Framework is a normative theory of accounting given that, based upon various perspectives about the objectives of general purpose financial reporting, it provides various prescriptions about how financial reports should be prepared. 5. Identify three theories that could be used to explain why particular regulation, such as specific regulation pertaining to financial reporting, has been enacted. LO 3.14 Three theories that could be used, and which were described in this chapter, include Public Interest Theory, Capture Theory and the Economic Interest Group Theory of Regulation. Each of these theories provides different perspectives about how, and why, particular regulations might be introduced. REVIEW QUESTIONS (KEY: Easy • Medium •• Hard •••) 1. What is the difference between a normative theory and a positive theory? Is one more useful than the other or do they perform different roles? LO 3.1, 3.9 •• 2. Can Positive Accounting Theory explain the existence of creative accounting? LO 3.2, 3.7 • 3. What is a systems-oriented theory of accounting? LO 3.10 • Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. 4. Why is it useful for students of financial accounting to consider theories such as those discussed in this chapter? LO 3.1 • 5. Why and how might management not act in the interests of the firm? LO 3.2, 3.4, 3.5 • 6. How can we use the output of the accounting system to help ensure that management’s actions are in the interests of the owners? LO 3.4 •• 7. How can management expropriate the wealth of debtholders? LO 3.2, 3.5 • 8. What is corporate social reporting? LO 3.10 • 9. Why would firms voluntarily present certain information, such as information about their performance with regard to the environment? LO 3.10, 3.11, 3.12, 3.13 •• 10. If firms are voluntarily producing information about the environment, about their initiatives with respect to their employees or about their commitments to the local population, what does this imply about their perceptions of who the ‘users’ of the information are? LO 3.10, 3.11, 3.12 •• 11. What are debt covenants and why are they put in place? LO 3.5 • 12. What might be a goal of a well-designed management compensation scheme? LO 3.4 • 13. What mechanisms could be put in place to motivate management to consider the interests of: (a) the owners? (b) the debtholders? LO 3.4, 3.5 • 14. What role does the auditor play in financial reporting? LO 3.3, 3.7 • 15. Why would a change in accounting policy affect a contractual agreement between a firm and a manager or debtholder? LO 3.4, 3.5 • Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 150 10/24/19 12:47 PM Chapter 3: Theories of financial accounting 151 16. Positive Accounting Theory utilises the concept of political costs. Briefly define political costs. What actions might a firm’s management undertake in an attempt to minimise the political costs that might be imposed on the firm? LO 3.6 •• 17. Explain why a firm’s management might be prepared to expend considerable resources to lobby ‘for’ or ‘against’ a proposed accounting standard. LO 3.3, 3.4, 3.5 •• 18. Chambers’ theory of accounting, Continuously Contemporary Accounting, relies on the notion of the ‘capacity to adapt’. What is the capacity to adapt and how is it determined? LO 3.9 • 19. Contrast the role of Positive Accounting Theory with the role of normative accounting theories. LO 3.1, 3.9 • 20. Under Positive Accounting Theory, what are agency costs of equity and agency costs of debt? Is it possible to put in place mechanisms to reduce all opportunistic action? If not, why not? LO 3.2, 3.3, 3.4, 3.5 •• 21. If we accept the assumptions of Positive Accounting Theory, would you expect a manager who is rewarded by way of a profit-sharing bonus scheme to prepare the firm’s financial statements in an unbiased manner? Explain your answer. LO 3.2, 3.3, 3.4 •• 22. Some researchers who utilise Legitimacy Theory posit that organisations will attempt to operate within the terms of their ‘social contract’. What is a social contract? LO 3.12 • 23. Using Institutional Theory as your theoretical basis, explain why an organisation might voluntarily elect to make particular financial disclosures. LO 3.13 •• 24. Within Institutional Theory, reference is made to isomorphism and decoupling. What do these terms mean? LO 3.13 • 25. If we accept the assumptions of Positive Accounting Theory, would you expect a manager who is employed by a firm that has negotiated lending agreements which include accounting-based debt covenants to have a relatively greater incentive to manipulate the financial statements? Explain your answer. LO 3.2, 3.3, 3.5, 3.7 ••• 26. The IASB’s Conceptual Framework for Financial Reporting indicates that financial statements should provide unbiased representations of the underlying transactions. Is this realistic? LO 3.2, 3.3, 3.9 •• 27. Provide some arguments to explain what motivates regulators to introduce particular regulations. LO 3.14 • Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. 28. Identify three potential limitations or shortcomings of Positive Accounting Theory. LO 3.8 • CHALLENGING QUESTIONS 29. Does the teaching of Positive Accounting Theory act to instil inappropriate values within the minds of students? LO 3.8 30. Read the following text, which has been adapted from ‘Reserve Bank put heat on Lehman over accounting’, by Kate Lahey and Leonie Wood, (The Age, 13 March 2010, Web). This article is about the collapse of the financial institution Lehman Brothers. The Reserve Bank of Australia (RBA) questioned Lehman Brothers’ representatives about transactions it believed were being used to conceal a debt of billions of dollars well before the bank collapsed so spectacularly in September 2008 and severely damaged the world financial markets. It appears the RBA was right to question the bank. A nine-volume, 2200-page report into Lehman’s bankruptcy by Anton Valukas, partner in the law firm Jenner & Block and examiner for the bank, was released on 12 March 2010. It contains copies of emails where Lehman employees discuss whether to reveal to the RBA vague or detailed reasons for Lehman’s accounting practices. The report revealed the causes of the demise of Lehman, including unsecured mortgages and insistence on collateral for loans sought by Lehman from its competitors Citigroup and JPMorgan Chase. The report outlined the ‘materially misleading’ accounting practices used by Lehman to conceal its financial woes and its dependence on borrowed money for survival. Senior Lehman executives and the bank’s accountants at Ernst & Young were aware that $50 billion was ‘removed’ from the accounts in the months before the collapse; Lehman’s CEO at the time, Richard Fuld Jr, certified the accounts were correct. The report said Fuld was ‘at least grossly Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 151 11/07/19 11:21 AM 152 PART 2: Theories of accounting negligent’; he’d been warned by the Treasury Secretary, Henry Paulson Jr, about the need for Lehman to stabilise its finances or find a buyer to stave off the possibility of collapse. Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. Both Lehman and Ernst & Young had ignored Matthew Lee, a senior vice-president, when he wrote to senior management and auditors about ‘accounting improprieties’. The report found Lehman’s board had not been informed of Lee’s claims and were unaware of the suspect accounting practices. Valukas stated that Lehman executives were involved in ‘actionable balance sheet manipulation’ and made ‘nonculpable errors of business judgment’ and suggested that there was enough evidence against them, and Ernst & Young, to support civil claims. ‘Our last audit of the company was for the fiscal year ending November 30, 2007. Our opinion indicated that Lehman’s financial statements for that year were fairly presented in accordance with Generally Accepted Accounting Principles (GAAP), and we remain of that view.’ This was the official response of Ernst & Young to the report by its representative, Charles Perkins. The accounting practice subject to scrutiny in a large part of the Valukas report is the use of repurchase agreements, known on Wall Street as ‘repos’ and as ‘Repo 105’ at Lehman Brothers. Repo 105 transactions, in use since 2001, moved billions off Lehman’s accounts when the bank came under scrutiny. It was the use of Repo 105 that the RBA had questioned. These were used extensively before the crash as Fuld Jr ordered his executives to reduce Lehman’s level of debt. Valukas quoted a Lehman executive’s email where it was said about Repo 105 that ‘It’s basically window-dressing’. For example, the amount moved off balance sheets in the final quarter of 2007 was $39 billion, in the first quarter of 2008, $49 billion, and in the second quarter of that year, $50 billion. At the same time the Lehman executives were insisting in public that its finances were in good shape. Fuld denied knowledge of the use of Repo 105, although it has been reported that Herbert McDade, Lehman’s ‘balance sheet czar’, told Fuld about the use of Repo 105. Following the release of the report, Lehman’s current CEO, Bryan Marsal, said that they will consider the report and ‘assess how it might help us in our ongoing efforts to advance creditor interests’. Lehman’s creditors in Australia will also be hoping that the report will assist with advancing their interests. Local councils and charities bought up to $1.2 billion of complex derivative instruments from Lehman before its collapse. Lehman’s biggest creditors by a deed of company arrangement sought to protect Lehman and third parties from claims from the councils. The councils are hoping the report strengthens their case to sue but they are waiting for a High Court ruling on the issue. REQUIRED (a) What does ‘window dressing’ mean in the context of this article? (b) What qualitative characteristics of the IASB Conceptual Framework would they have potentially breached? (c) Are firms more likely to engage in ‘window dressing’ their financial statements when they have relatively high levels of debt rather than low levels of debt? Why? LO 3.2, 3.5 31. What is a theory and how would you evaluate whether a theory is a ‘good’ theory or a ‘bad’ theory? Is there actually such a thing as a good or a bad theory? LO 3.1 32. Do you expect that we will ever have a single universally accepted theory of accounting? If not, why not? LO 3.1 33. Professional accountants are expected to be objective when performing their duties. How would you reconcile this expectation with the central assumptions of Positive Accounting Theory, and are they mutually exclusive? LO 3.2, 3.3, 3.4, 3.5, 3.6, 3.7 34. How could accounting regulators use the research conducted by Positive Accounting theorists? LO 3.4, 3.5, 3.6, 3.7, 3.14 35. According to Positive Accounting Theory, why could a change in the existing set of accounting standards affect the value of a firm? LO 3.3 Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 152 10/24/19 12:47 PM Chapter 3: Theories of financial accounting 153 36. If management agrees to restrict its ability to transfer wealth away from debtholders—perhaps through agreeing not to pay excessive dividends; not to take on excessive levels of debt; or not to participate in excessively risky ventures—what effect should this have on the cost of debt capital of the firm? LO 3.5 37. In an article that appeared in The Australian on 28 July 2014 entitled ‘Southern Cross CFO quit over writedown’ (by Darren Davidson) it was reported that: Mr Lewis joined Southern Cross after it issued a profit downgrade in May. The owner of the 2DayFM radio network said that it expected full-year net profit to fall 10 per cent below the previous year’s underlying NPAT of $89 million. Although the company’s gearing remains within its banking covenant of less than 3.5 times earnings before interest, taxes, depreciation and amortisation, there is concern in the market the company is slipping into a danger zone with its debt covenants. Some market analysts believe that if revenues continue to deteriorate, gearing of above three times EBITDA could trigger a breach of banking covenants. REQUIRED (a) Why might the debt covenants have originally been agreed to by Southern Cross? (b) Why would a reduction in earnings potentially affect the debt covenants? (c) In general, and according to the ‘debt hypothesis’ often utilised within Positive Accounting Theory, if an entity is close to breaching accounting-based debt covenants then what action might the entity take? LO 3.2, 3.5 38. Read the brief extract from Anthony Hughes’ article ‘Credit card profit soars but ANZ feels no guilt’ (The Sydney Morning Herald, 27 April 2001, p.3) and answer the following questions (be specific about the theories you are using when providing your answers). Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. ANZ denied yesterday it was overcharging customers after reporting a 71 per cent increase in credit card profits. The bank also reported a 93 per cent profit rise from mortgages. The overall net profit for the March half was $895 million, a record for the bank. The result comes just a week after the bank unveiled a plan to tackle community concern about banking standards, including a new customer charter, fee-free over-the-counter banking for people over 65 and the appointment of a senior customer advocate. ANZ’s chief executive, Mr John McFarlane, defended the credit card profits. ‘. . . These are not unfair businesses and we are not getting unusual levels of returns,’ he said. Mr McFarlane admitted the banks had been slow to recognise the depth of community concern. ‘Whether we are going to be regulated or not we are going to have to do things differently.’ REQUIRED (a) Why do you think the bank ‘unveiled a plan to tackle community concerns’? (b) What do you think motivates the government to take action against the banks? (c) The bank’s reported profit seems to be an issue of concern. Do you think that community concern about the actions of the bank would be as great if the bank was not so profitable? (d) Do you think that community concerns about the profits made by banks might motivate the banks to adopt accounting policies that reduce their reported profits? Explain your answer. LO 3.2, 3.6, 3.10, 3.12 39. Read the brief extract from an article by Sue Mitchell entitled ‘Retailers face multibillion-dollar hit from proposed lease accounting changes’ (The Canberra Times, 22 April 2015, Web) and answer the questions that follow. Australia’s fastest growing retailers face a hit to their bottom line profits under proposed accounting rules that will force them to bring more than $40 billion worth of leases onto their balance sheets for the first time. Under the latest changes to lease accounting rules put forward by the IASB, retailers such as Woolworths, Wesfarmers, Myer, David Jones, JB Hi-Fi, Harvey Norman, Specialty Fashion and Premier Investments will have to calculate the net present value of future lease commitments and recognise them as debt on their balance sheets. Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 153 10/24/19 12:47 PM 154 PART 2: Theories of accounting Instead of recognising rent payments as costs incurred, retailers will have to expense theoretical amortisation and financing costs. According to a report by Morgan Stanley, the impact on retailers will be ‘considerable’, blowing out gearing levels and reducing return on capital employed, but will vary from retailer to retailer. KPMG audit partner Patricia Stebbens said the proposed changes would boost gearing ratios, forcing some companies to renegotiate debt covenants with bankers. REQUIRED (a) Why would companies have preferred to treat the leases as operating leases (if there is an operating lease then the assets and liabilities associated with the leased asset are not shown on the statement of financial position) rather than finance leases (if the lease were a finance lease then the liabilities and assets associated with the lease would be shown on the statement of financial position)? (b) Explain why the change in the accounting standard for leasing might cause organisations to breach covenants included within debt contracts. (c) What is the difference between debt covenants that rely upon ‘floating GAAP’ and those relying on ‘fixed GAAP’, and which provide less risk to the borrower? (d) Which organisations would be more likely to lobby against the accounting standard? LO 3.2, 3.3, 3.4, 3.5 40. The accounting standard AASB 138 Intangible Assets requires Australian companies to expense research expenditure instead of treating it as an asset. REQUIRED Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. (a) Construct three hypotheses based on each of the three major components of Positive Accounting Theory to predict which companies are more likely to prefer to recognise research expenditure as an asset, rather than being required to treat the related expenditure as an expense. (b) Suggest how a researcher might test these hypotheses. LO 3.2, 3.3, 3.4, 3.5, 3.6 41. In 2006 the Australian Government established an inquiry into corporate social responsibilities with the aim of deciding whether the Corporations Act should be amended so as to specifically include particular social and environmental responsibilities within the Act. At the completion of the inquiry it was decided that no specific regulations would be added to the legislation, and that instead, ‘market forces’ would be relied upon to encourage companies to do the ‘right thing’ (that is, the view was expressed that if companies did not look after the environment, or did not act in a socially responsible manner, then people would not want to consume the organisations’ products, and people would not want to invest in the organisations, work for them, and so forth. Because companies were aware of such market forces they would do the ‘right thing’ even in the absence of legislation). You are required to explain the decision of the government that no specific regulation be introduced from the perspective of: (a) Public Interest Theory (b) Capture Theory (c) Economic Interest Group Theory of Regulation. LO 3.14 42. Read the following extract from an article by Greg Barnes entitled ‘Time for a free market in Tasmanian tourism’, The Mercury, 8 December 2014. Web) and then answer the questions that follow. American economist George Stigler wrote ‘as a rule, regulation is acquired by the industry and is designed and operated primarily for its benefit’. Stigler’s theory of regulatory capture is a sound one and we are witnessing its pernicious impact in Tasmania today. The tourism industry in Tasmania, through its lobby groups the Tourism Council and the Hospitality Association, is embarking on a concerted campaign against . . . ‘rogue’ operators. It wants government to police barriers to entry into the tourism industry. It is doing so because it wants to curtail competition and it is dressing up its regulatory capture strategy by pretending that it is campaigning on behalf of consumers. The Tourism Council is an opponent of the website Airbnb . . . The outrage is pure self-interest of course. Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 154 10/24/19 12:47 PM Chapter 3: Theories of financial accounting 155 Regulatory capture is the curse of modern democracy. It erodes competition, innovation and consumer choice. . . . The Tasmanian Government should ignore the media campaign being run by vested interests that are afraid of the chill winds of market forces. REQUIRED (a) Pursuant to Capture Theory, why would the Tasmanian Government respond to the demands of the tourism industry? (b) From a Capture Theory perspective, who benefits from government regulation? (c) Would it be possible to ‘prove’ that the Tasmanian Government has been ‘captured’ by the tourism industry, and if so, what evidence would provide such proof? LO 3.14 FURTHER READING The following texts are dedicated to financial accounting theory and are useful references for readers who want to gain additional insights into the topic: Deegan, C., 2014, Financial Accounting Theory, 4th edn, McGrawHill, Sydney (new edition forthcoming). Gray, R., Adams, C. & Owen, D., 2014, Accountability, Social Responsibility and Sustainability, Pearson Education, London. Scott, W., 2015, Financial Accounting Theory, 7th edn, Pearson Education, Toronto. Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. REFERENCES Anagnostopoulou, S. & Tsekrekos, A., 2017, ‘The Effect of Financial Leverage on Real and Accrual-based Earnings Management’, Accounting and Business Research, vol. 47, no. 2, pp. 191–236. Australian Accounting Standards Board, 2019, Conceptual Framework for Financial Reporting, AASB, Melbourne, May. 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Zang, A., 2012, ‘Evidence on the Trade-off Between Real Activities Manipulation and Accrual-Based Earnings Management’, The Accounting Review, vol. 87, no. 2, pp. 675–803. Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 157 10/24/19 12:47 PM Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. Deegan, C. (2019). Financial accounting. McGraw-Hill Education (Australia) Pty Limited. Created from deakin on 2022-11-10 03:40:15. dee67382_ch03_099-158.indd 158 10/24/19 12:47 PM