Chapter 3
Theories of financial
accounting
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3-1
Objectives
• Be able to describe various normative and positive
theories of financial accounting
• Be aware of some of the limitations of the various
theories of accounting
• Appreciate that there is no single unified theory of
accounting
• Understand the various pressures and motivations that
might have an effect on the methods of accounting
selected by an organisation
• Understand what is meant by ‘creative accounting’ and
why it might occur
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3-2
Theory definition
• A coherent group of propositions or principles forming
a general framework of reference for a field of inquiry
• Accounting theories explain and predict accounting
practice (positive theories) or prescribe particular
practice (normative theories)
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3-3
Positive Accounting Theory (PAT)
• Positive Accounting Theory is an example of an
example of a positive theory of accounting. As we will
see later, there are other positive theories of
accounting (as well as normative theories of
accounting)
• PAT Explains and predicts accounting practice
• Does not seek to prescribe particular actions
• Grounded in economic theory
• Focuses on the relationships between various
individuals involved in providing resources to an
organisation (agency relationship)
– owners and managers
– managers and debt providers
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3-4
Positive Accounting Theory (PAT)
(cont.)
Agency theory
• Agency relationship
– delegation of decision making from the principal to the agent
• Agency problem
– delegation of authority can lead to loss of efficiency and
increased costs
• Agency costs
– costs that arise as a result of the agency relationship
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3-5
Positive Accounting Theory (PAT)
(cont.)
Agency costs
• Monitoring costs
• Bonding expenditures
• Residual loss
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3-6
Positive Accounting Theory (PAT)
(cont.)
Assumptions of PAT
• All individual action is driven by self-interest (do we
think this is a realistic assumption?)
• Individuals will act in an opportunistic manner to
increase their wealth
• Notions of loyalty and morality are not incorporated
within the theory
• Organisations are a collection of self-interested
individuals who agree to cooperate to the extent it is in
their interest
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3-7
Positive Accounting Theory (PAT)
(cont.)
PAT predictions
• Organisations will seek to put in place mechanisms
to align the interests of managers of the firm (agents)
with the interests of the owners (principals)
• Some of these mechanisms rely on the output of the
accounting system
– for example, the owners might agree to pay the manager a
bonus based on a specified percentage of profits
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3-8
Positive Accounting Theory (PAT)
(cont.)
Efficiency and opportunistic perspectives of PAT
• Efficiency perspective
– mechanisms are put in place up front with the objective of minimising
future agency costs
 For example, reward structures might be implemented to motivate and
retain managers, perhaps by providing them with bonuses tied to
accounting profits, or providing them with shares or options
 Voluntary audits might be undertaken to reduce the perceived risks of
investors
– referred to as ex ante perspective
– accounting methods adopted by firms best reflect the underlying
financial performance of the entity – might select the most efficient
way to portray the performance of the entity
– regulation is therefore argued by PAT advocates to impose
unwarranted costs on reporting entities – causes the firm to provide
an inefficient perspective of the performance and position of the
organisation as it requires movement to a one-size-fits-all approach
to reporting
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3-9
Positive Accounting Theory (PAT)
(cont.)
Efficiency and opportunistic perspectives of PAT (cont.)
• Opportunistic perspective
– considers opportunistic actions that could be taken once
various contractual arrangements have been put in place
 For example, once a profit sharing scheme has been put in place
to motivate managers to increase the value of the organisation
(that is, put in place for efficiency reasons), managers will – to
the extent they can get away with it – be predicted to try to
manipulate reported profits so as to generate the greatest wealth
transfer to themselves
– assumes managers will opportunistically select accounting
methods to increase their own personal wealth
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3-10
Positive Accounting Theory (PAT)
(cont.)
Owner/Manager contracting
• Managers assumed to act in their own self-interest
at the expense of owners
– ‘Rational economic person’ assumption
• Managers have access to information not available
to principals
– Information asymmetry
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3-11
Positive Accounting Theory (PAT)
(cont.)
Owner/Manager contracting (cont.)
• Methods of reducing agency costs of equity
–
–
–
–
price protection
monitoring by owners
bonding by managers
managers may be rewarded:
 on a fixed basis
 on the basis of the results achieved
 on a basis that combines the two
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3-12
Positive Accounting Theory (PAT)
(cont.)
Bonus schemes
• Remuneration based on the output of the accounting
system
• Very common and their existence can be explained by
PAT
• Bonuses might be based on:
– profits of the firm
– sales of the firm
– return on assets
• May also be rewarded based on market price of
shares
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3-13
Positive Accounting Theory (PAT)
(cont.)
Accounting-based bonus schemes
• Any changes in the accounting methods used by the
organisation will affect the bonuses paid (e.g. as a
result of a new accounting standard)
• Changing the bonuses paid impacts cash flows, and
this in turn is predicted to impact the value of the
organisation
• Contracts may rely on ‘floating’, generally accepted
accounting principles
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3-14
Positive Accounting Theory (PAT)
(cont.)
Incentives to manipulate accounting numbers
• Rewarding managers on the basis of accounting
profits can induce them subsequently to manipulate
the related accounting numbers to improve their
apparent performance and thus the related rewards
• Accounting profits might not always provide an
unbiased measure of a firm’s performance – so also
common to find the use of share-based reward
structures, which in certain circumstances, might be
deemed to be more efficient
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3-15
Positive Accounting Theory (PAT)
(cont.)
Market-based bonus schemes
• Market prices are assumed to be influenced by
expectations about the net present value of
expected future cash flows
• Cash bonuses might be awarded on the basis of
increases in share prices
• Shares or options to shares might also be provided
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3-16
Positive Accounting Theory (PAT)
(cont.)
Market-based bonus schemes
• Market prices reflect market-wide factors, not just
those factors controlled by the manager
• Only senior management will be likely to be able to
affect cash flows and hence securities prices
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3-17
Positive Accounting Theory (PAT)
(cont.)
Role of auditor
• If managers’ remuneration is based on accounting
numbers the auditor takes a monitoring role
• The auditor arbitrates on the reasonableness of the
accounting methods adopted
• Some research indicates that the greater the
separation between managers and owners, and the
greater the reliance on external debt (meaning greater
potential agency costs), the greater the likelihood that
voluntary financial statements would be undertaken
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3-18
Positive Accounting Theory (PAT)
(cont.)
Other mechanisms that align the interests of managers
and owners
• Threat of takeovers to underperforming firms
• A well-informed labour market
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3-19
Positive Accounting Theory (PAT)
(cont.)
Debt contracting
• Agency costs of debt:
–
–
–
–
excess dividends
claim dilution
asset substitution
investment in risky projects
• When discussing the agency costs of debt it is
assumed that the managers’ interests are aligned with
the shareholders’ interests
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3-20
Positive Accounting Theory (PAT)
(cont.)
Ways to minimise the agency costs of debt
• Price protection
– higher interest charges to compensate for risk
• Contracting
– interest coverage clauses
– debt to asset clauses
 Leverage clauses frequently used in Australian bank loan
contracts
• Monitoring
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3-21
Positive Accounting Theory (PAT)
(cont.)
Political costs
• Costs that groups external to the firm might be able to impose on
the firm:
–
–
–
–
increased taxes
increased wage claims
product boycotts
decreased subsidies
• Organisations are affected by governments, trade unions,
environmental lobby groups or particular consumer groups
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3-22
Positive Accounting Theory (PAT)
(cont.)
Political costs (cont.)
• Demands placed on the firm might be affected by
accounting results
– higher reported profits
– how accounting numbers are generated is not important
• Accounting numbers might be used as a means of
providing ‘excuses’ for effecting wealth transfers in the
political process
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3-23
Positive Accounting Theory (PAT)
(cont.)
Ways to reduce political costs
• Management might:
– adopt income-reducing accounting techniques
– make voluntary social disclosures
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3-24
Discussion leads to 3 main hypotheses of
PAT
• The bonus plan hypothesis is that managers of firms
with bonus plans are more likely to use accounting
methods that increase current period reported income.
• The debt/equity hypothesis predicts that the higher the
firm’s debt/equity ratio, the more likely managers use
accounting methods that increase income.
• The political cost hypothesis predicts that large firms
rather than small firms are more likely to use
accounting choices that reduce reported profits.
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3-25
PAT in summary
• Selection of accounting methods can be explained by either
efficiency or opportunistic arguments
• Accounting methods can impact on cash flows associated with
debt and management compensation contracts
• These effects can be used to explain why particular accounting
methods are used
• The use of particular accounting methods can have conflicting
effects
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3-26
Accounting policy selection
and disclosure
• To allow comparison between reporting entities
– a summary of accounting policies must be presented in the
notes to the financial report (AASB 101, par. 108)
– where an accounting policy has changed and the change has
a material effect on results the notes must disclose the nature
of, reason for, and financial effect of the change (AASB 108,
par. 29)
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3-27
Accounting policy selection
and disclosure (cont.)
Accounting policy choice and ‘creative accounting’
• ‘Creative accounting’ refers to selecting accounting
methods that provide the result desired by the
preparers
• Also known as opportunistic
• Can be explained by PAT
• It is possible to be creative and still follow
accounting standards
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3-28
Criticisms of PAT
• Does not provide prescription so does not provide a means of
improving accounting practice
• Not value-free but rather value-laden
• Underlying assumption of wealth maximisation is simplistic
• Issues being addressed have not shown any significant
development
• Scientifically flawed
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3-29
Normative accounting theories
• Seek to provide guidance in selecting accounting
procedures that are most appropriate
• Prescribe what should be done
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3-30
Normative accounting theories ( cont.)
The Conceptual Framework:
• is considered a normative theory
• seeks to identify the objective of GPFR
• seeks to provide recognition and measurement rules
within a ‘coherent’ and ‘consistent’ framework
• identifies the qualitative characteristics financial
information should possess
• makes recommendations that depart from current
practice
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3-31
Normative accounting theories ( cont.)
Other normative theories
• Three main classifications
1. current-cost accounting
2. exit-price accounting
3. deprival-value accounting
•
•
These theories addressed issues associated with
changing prices
Developed in 1950s and 1960s during a period of
high inflation
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3-32
Normative accounting theories ( cont.)
Current-cost accounting
• Aim is to provide a calculation of income that, after
adjusting for changing prices, can be withdrawn from
the entity and still leave the physical capital (operating
capacity) of the entity intact
– referred to as true measure of income
• True income theories propose a single measurement
basis for assets and a resultant single measure of
income (profit)
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3-33
Normative accounting theories ( cont.)
Exit-price accounting
• Continuously Contemporary Accounting
• Uses exit or selling prices to value the entity’s assets and
liabilities
– referred to as current cash equivalents
• Assumptions:
– firms exist to increase the wealth of their owners
– the ability to adapt to changing circumstances
– capacity to adapt best reflected by current selling prices
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3-34
Normative accounting theories ( cont.)
Deprival-value accounting
• Deprival value represents the amount of loss that
might be incurred by an entity if it were deprived of the
use of an asset and the associated economic benefits
• This method considers:
– the net selling price
– the present value of future cash flows
– an asset’s current replacement cost
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3-35
Systems-oriented theories
Systems-oriented theories
• These theories focus on the role of information and
disclosure in the relationships between
organisations, the State, individuals and groups
• The entity is assumed to be influenced by the
society in which it operates and to have an influence
on it
• Systems-based theories include:
– stakeholder Theory
– legitimacy Theory
– institutional Theory
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3-36
Systems-oriented theories (cont.)
Stakeholder Theory
• Two branches
1. Ethical (normative) branch
2. Managerial (positive) branch
•
Ethical (normative) branch
–
–
–
–
stakeholders are any group or individual who can affect or are
affected by the achievement of the firm’s objectives
includes shareholders, employees, customers, lenders,
suppliers, local charities, interest groups, government, etc.
all stakeholders have a right to be provided with information
because it prescribes how stakeholders should be treated
(based on various ethical perspectives), it is a normative
approach
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3-37
Systems-oriented theories (cont.)
Stakeholder Theory (cont.)
• Managerial (positive) branch
– seeks to explain and predict how an organisation will react to
demands of various stakeholders
– relative power or importance of stakeholders considered
– relative power and importance can change across time—associated
with control of resources
– the firm will take actions to ‘manage’ its relationships with
stakeholders
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3-38
Systems-oriented theories (cont.)
Stakeholder Theory (cont.)
• Stakeholder Theory (either branch) does not prescribe
what information should be disclosed, other than
indicating that the provision of information can be
useful for the continued operations of the entity
• Managerial branch (cont.)
– financial and social information is used to control conflicting
demands of various stakeholder groups
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3-39
Systems-oriented theories (cont.)
Legitimacy Theory
• Organisations continually seek to ensure that they
operate within the bounds and norms of society
• Organisations attempt to ensure their activities are
perceived to be legitimate
• Bounds and norms change across time
• Based on a ‘social contract’ between society and the
organisation
• Where this social contract is perceived as being
breached then the organisation will take corrective
action, and this action might include disclosure
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3-40
Systems-oriented theories (cont.)
Legitimacy Theory (cont.)
• Organisations must appear to consider the rights of
the public at large, not just investors
• To gain or maintain legitimacy, organisations might rely
on disclosure within their annual report
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3-41
Systems-oriented theories (cont.)
Institutional Theory
• Explains why organisations within particular ‘fields’ tend to take
on similar characteristics and form
• Much overlap with Legitimacy Theory and Stakeholder Theory
• Two main dimensions to the theory – isomorphism and
decoupling
• Isomorphism
– coercive
– mimetic
– normative
• Decoupling
– actual practices can be very different from formally sanctioned and
publicly pronounced processes and practices
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3-42
Theories explaining why regulation
is introduced
• Just as there are theories to explain why particular
accounting disclosures are made (PAT, Legitimacy
Theory, Stakeholder Theory), or why particular
organisational forms exist (institutional theory), there
are also theories to explain why particular
regulations (for example, accounting regulations)
are developed. Such theories include:
– Public interest theory
– Capture theory
– Economic interest group theory
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3-43
Theories explaining why regulation is
introduced (cont.)
Public interest theory
• Regulation put in place to benefit society as a whole
rather than vested interests
• Regulatory body considered to represent the interests
of the society in which it operates, rather than the
private interests of the regulators
• Assumes that government is a neutral arbiter
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3-44
Theories explaining why regulation is
introduced (cont.)
Capture theory
• The regulated seeks to take charge (capture) the
regulator
• They seek to ensure rules subsequently released are
advantageous to the parties subject to regulation
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3-45
Theories explaining why regulation is
introduced (cont.)
Economic interest group theory
• Assumes groups will form to protect particular
economic interests
• Groups are often in conflict with each other and will
lobby government to put in place legislation that will
benefit them
at the expense of others
• No notion of public interest inherent in the theory
• Regulators (and all other individuals) deemed to be
motivated by self-interest
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3-46
Theories explaining why regulation is
introduced (cont.)
Economic interest group theory (cont.)
• The regulator is not a neutral arbiter but is seen as an interest
group
• Regulator is motivated to ensure re-election or maintenance of its
position of power
• Regulation serves the private interests of politically effective
groups
• Those groups with insufficient power will not be able to lobby
effectively for regulation to protect their own interests
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3-47
Summary
• The chapter describes various theories that relate to financial
accounting
• No single accounting theory is universally accepted
• Positive Theory of Accounting
– seeks to explain and predict accounting-related phenomena
– e.g. study of capital market’s reaction to particular
accounting policies, what motivates managers to select a
given method of accounting, reasons for the existence of
particular accounting-based contracts
– relies upon a fundamental assumption that individual action
can be predicted on the basis that all action is driven by a
desire to maximise wealth (a perspective often criticised by
other researchers)
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3-48
Summary (cont.)
Normative theories of accounting
– prescribe how accounting should be practised
– argue typically that a central role of accounting theory is
to provide prescription—inform about optimal accounting
approaches and why a particular approach is considered
optimal
– examples: Conceptual Framework Project, current-cost
accounting, exit-price accounting and deprival-value
accounting
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3-49
Summary (cont.)
Systems-based theories
• Include Stakeholder Theory, Legitimacy Theory, and Institutional
Theory
– see organisation as firmly embedded within a broader social
system
– organisation is considered to be affected by, and to affect, the
society in which it operates
– accounting disclosures and particular organisational forms are
seen as a way to manage relations with particular groups
outside the organisation— organisational activities and
accounting disclosures are considered to be reactive to
community pressures—how a firm operates and what it
reports must be determined upon consideration of various
stakeholder expectations
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3-50
Summary (cont.)
Theories that seek to explain how regulation is
developed
• Some theories suggest that regulation is introduced to
serve the public interest by regulators who work for the
public good
• Other theories of regulation assume that the development
of regulation is driven by considerations of self-interest
• Overall, the selection of one theory over another will
depend on the views and expectations of the researcher
in question
• No one theory of accounting can be described as a ‘best’
theory—however, different theoretical perspectives can at
various times provide valuable insights in accounting
issues
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3-51