Chapter 2
Theories of financial accounting
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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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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 practice
(normative theories)
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Positive Accounting Theory (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
(continues)
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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
(continues)
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Positive Accounting Theory (PAT)
(cont.)
Agency costs
• Monitoring costs
• Bonding expenditures
• Residual loss
(continues)
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Positive Accounting Theory (PAT)
(cont.)
Assumptions of PAT
• All individual action is driven by self-interest
• 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
(continues)
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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
(continues)
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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
– Referred to as ex ante perspective
– Accounting methods adopted by firms best reflect the underlying
financial performance of the entity
– Regulation is therefore argued to impose unwarranted costs on
reporting entities
(continues)
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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
Assumes managers will opportunistically select accounting
methods to increase their own personal wealth
(continues)
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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
(continues)
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Positive Accounting Theory (PAT)
(cont.)
Owner/Manager contracting (cont.)
• Methods of reducing agency costs of equity
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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
(continues)
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Positive Accounting Theory (PAT)
(cont.)
Bonus schemes
• Remuneration based on the output of the accounting system
• Based on:
–
profits of the firm
– sales of the firm
– return on assets
•
May also be rewarded based on market price of shares
(continues)
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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)
• Contracts may rely on ‘floating’, generally accepted
accounting principles
(continues)
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Positive Accounting Theory (PAT)
(cont.)
Incentives to manipulate accounting numbers
• Rewarding managers on the basis of accounting
profits can induce them 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
(continues)
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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
(continues)
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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
(continues)
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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
(continues)
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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
(continues)
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Positive Accounting Theory (PAT)
(cont.)
Debt contracting
• Agency costs of debt:
–
–
–
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excess dividends
claim dilution
asset substitution
investment in risky projects
• It is assumed that the managers’ interests are aligned
with the shareholders’ interests
(continues)
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Positive Accounting Theory (PAT)
(cont.)
Ways to minimise the agency costs of debt
• Price protection
–
Higher interest charges
• Contracting
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–
Interest coverage clauses
Debt to asset clauses
▪
Leverage clauses frequently used in Australian bank loan
contracts
• Monitoring
(continues)
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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
(continues)
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Positive Accounting Theory (PAT)
(cont.)
Political costs (cont.)
• Demands placed on the firm might be affected by
accounting results
–
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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
(continues)
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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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PAT in summary
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•
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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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Accounting policy selection
and disclosure
• To allow comparison between reporting entities:
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–
a summary of accounting policies must be presented in the
notes to the financial report (AASB 1001.6.1)
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 1001.6.2)
▪
This requirement is consistent with SAC 3
(continues)
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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
• It is possible to be creative and still follow
accounting standards
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Criticisms of PAT
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•
•
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•
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
Issues being addressed have not shown any significant
development
Scientifically flawed
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Normative accounting theories
• Seek to provide guidance in selecting accounting
procedures that are most appropriate
• Prescribe what should be done
(continues)
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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
(continues)
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Normative accounting theories ( cont.)
Other normative theories
•
Three main classifications:
current-cost accounting
2. exit-price accounting
3. deprival-value accounting
1.
•
•
These theories addressed issues associated with changing
prices
Developed in 1950s and 1960s during a period of high inflation
(continues)
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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)
(continues)
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Normative accounting theories ( cont.)
Exit-price accounting
• Continuously Contemporary Accounting
• Uses exit or selling prices to value the entity’s assets and
liabilities
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•
Referred to as current cash equivalents
Assumptions:
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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
(continues)
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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:
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–
–
the net selling price
the present value of future cash flows
an asset’s current replacement cost
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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
(continues)
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Systems-oriented theories (cont.)
Stakeholder Theory
•
Two branches:
1.
2.
•
ethical (normative) branch
managerial (positive) branch
Ethical branch
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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
(continues)
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Systems-oriented theories (cont.)
Stakeholder Theory (cont.)
• Managerial 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
(continues)
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Systems-oriented theories (cont.)
Stakeholder Theory (cont.)
• Managerial branch (cont.)
–
•
Financial and social information is used to control conflicting
demands of various stakeholder groups
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
(continues)
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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
(continues)
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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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Theories explaining why regulation
is introduced
• Public interest theory
• Capture theory
• Economic interest group theory
(continues)
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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
(continues)
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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
(continues)
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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
(continues)
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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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Summary
•
•
•
•
The chapter describes various theories that relate to financial
accounting
No single accounting theory is universally accepted
A theory is defined as a ‘coherent group of propositions used as an
explanation for a class of phenomena’
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 accountingbased contracts
Relies upon a fundamental assumption that individual action can
be predicted on the basis that all action is driven be a desire to
maximise wealth (a perspective often criticised by other
researchers)
(continues)
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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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Summary (cont.)
Systems-based theories
•
Include Stakeholder Theory and Legitimacy 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 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
(continues)
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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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