TOPIC 3: Business Decision Making Related to

Measurement and Disclosure and the Role of

Accounting Theories Part B
Chapter 5

Accounting Theory and Analysis 308

School of Accounting

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Materials prepared by Lisa Cullen, selected slides

from
Godfrey, J., A. Hodgson, A. Tarca, J. Hamilton, and
S. Holmes, 2010. Accounting Theory. Wiley
Rankin, M. 2012. Contemporary Issues in
Accounting, Wiley 2012 John Wiley & Sons
Australia Ltd
Deegan, C. 2009, Financial Accounting Theory,
McGrawHill

Chapter 5
Theories in
Accounting

What Value Does Theory

Offer?
Theories guide many activities
Accounting theories help us
understand
Decisions of financial report prepares
Actions of financial report users
Influences of organisational environment
Potentially better measurement and
reporting

Accounting is a human activity

Types Of Theories
Normative Theories
Recommend what should happen
Prescribe action to achieve specific
objectives
E.g. The Conceptual Framework

Positive Theories
Describes, explains or predicts activities
Help us understand what happens in the
world
E.g. Agency theory

Positive Accounting Theory

Used to explain and predict accounting practice.
It examines a range of relationships between the entity
and
suppliers of equity capital (owners),
managerial labour (management)
debt capital (lenders or debt holders)

based on the rational economic person assumption

assumes investors and financial accounting users and
preparers are rational utility maximisers
Also described as self-interested wealth maximisers

In order to prescribe an appropriate accounting policy, it

is necessary to know how the world actually operates.
We can then normatively prescribe accounting practice

Contracting Theory
Suggests that the organisation is characterised
as a legal nexus of contracts.
With contracting parties having rights and
responsibilities under these contracts.
Positive accounting theory focuses on
managerial contracts, and
debt contracts,

These are agency contracts used to manage

relationships where there is a separation
between management and capital providers.
(information asymmetry)

Agency Theory
Used to understand relationships whereby a
principal employs the services of, and
delegates the decision making authority to, an
agent.
How do owners restrict
Creates a moral hazard.
managers as agents
Leads to 3 costs
opportunistic or selfinterest behaviour?
Monitoring costs audit
Bonding costs salaries, bonus, restrict accounting
policy choices
Residual loss cant remove all opportunistic costs.

OwnerManager
Agency Relationships
Agency theory identifies a number of
problems that can exist between
managers and owners.
Contracts and accounting information
can be used to bond the interests of
owners and managers.
Addresses 3 specific problems
Horizon problem
Risk aversion
Dividend retention.

ManagerLender
Agency Relationships
When a lender agrees to provide funds to an entity there is
the risk that the lending party may not repay those funds.
Excessive dividend payments (fewer assets to pay debt)
Underinvestment or over investment in high risk projects
Asset substitution (lower value)
Claim dilution (taking on more debt)

Debt holders charge interest in line with risk - To avoid

higher interest costs managers have incentives to show
they are acting in a way that is not detrimental to lenders.
Note: Research has found Managers have manipulated
accounting accruals in the years before and the year after
violation of a debt agreement.
Auditors need to be vigilant

Australian debt contracts

In relation to Australian debt contracts, Cotter (1998) found

leverage covenants frequently used in bank loan
contracts
leverage most frequently measured as the ratio of total
liabilities to total tangible assets
prior charges covenants typically included in term loan
agreements of larger firms
prior charges covenants defined as a percentage of total
tangible assets
debt to assets, interest coverage and current ratio
clauses frequently in use
interest coverage required to be between 1 and 4
times
current ratio clauses required current assets be
between 1 and 2 times the size of current 10
liabilities

Role of Accounting Information

in Reducing Agency Problems
Accounting information forms one of the major
components of both manager remuneration and
lending contracts.
For managers accounting information plays two
roles in the contracting process:
1. To write the terms of managerial contracts.
2. To determine performance against the terms of the
contracts and consequently the amount of bonus and
other pay components managers will receive.

Lenders look to regular financial updates to ensure

companies are maintaining the terms of their
covenants.

Information
Asymmetry
Results from managers having more
information about the current and
future prospects of the entity than
outsiders.
Managers can choose when and how
to disseminate this information.
Under positive accounting theory
there are incentives to disclose most
news, good or bad, to the market.

Key Hypotheses
Three key hypotheses frequently used in PAT
literature to explain and predict support or
opposition to an accounting method
bonus plan hypothesis (bonus attached to profits)
debt hypothesis (debt covenants)
political cost hypothesis (large firms may seek to
choose methods to reduce reported profits)

Research assumes managers will act

opportunistically when selecting methods

13

Incentives to manipulate accounting numbers

Rewarding managers on the basis of accounting

profits may induce them to manipulate
accounting numbers (the opportunistic
perspective)
will affect their rewards
Bonuses based on profits cause short-term rather
than long-term focus
may affect investment in positive NPV projects
if returns not expected to be consistent
Evidence shown in studies by Healy (1985) &
Lewllen et al (1987)
14

Market-based bonus schemes

May be more appropriate to remunerate managers in terms of
market value where accounting earnings fluctuate greatly
e.g. mining, or high technology R&D firms
Methods include
cash bonus based on share price increases
shares
options to shares
Managers have incentives to increase the value of the firm
Problems include
share price also affected by factors beyond the control of
managers (e.g. general market movements)
only senior managers likely to have a significant impact on
share value
15

Institutional Theory
Comes from management literature.
It considers how rules, norms and routines
become established as authoritative
guidelines, and considers how these
elements are created, adopted and
adapted over time.
Practices within organisations can be
predicted from perceptions of legitimate
behaviour derived from cultural values,
industry tradition, entity value etc

Comparison of Agency and

Institutional Theories

Legitimacy Theory
Based on the idea of a social contract
Relates to the explicit and implicit expectations society
has about how businesses should act to ensure they
survive into the future.
The values and norm evident in the social contract have
changed over time.
Organisations need to show they are operating in
accordance with the expectations in the social contract.
In the past legitimacy was considered only in terms of
economic performance.
Now businesses are now expected to consider a range of
issues, including the environmental and social
consequences of theirImplications
activities. of not meeting the social
contract?
Legal restrictions
Limited resources provided

Accounting Disclosures
and Legitimation
Lindblom identifies four ways an organisation
can obtain or maintain legitimacy:
1. Seek to educate and inform society about actual
changes in the organisations performance and
activities
2. Seek to change the perceptions of society, but
not actually change behaviour
3. Seek to manipulate perception by deflecting
attention from the issue of concern to other
related issues
4. Seek to change expectations of its performance.

Accounting Disclosures
and Legitimation
Disclosure of information about an organisations effect
on, or relationship with society can be used in each of
the strategies.
An entity might provide information to offset negative news
which may be publicly available.
An organisation may draw attention to strengths.

Public reporting through the annual report or the entity

website can be a powerful tool in showing an
organisation is meeting the expectations of society.
Accounting numbers can also be manipulated to show
lower profits for example if a particular industry is under
scrutiny for making too high profits (thereby addressing
part of the perceived social contract)

Legitimacy Theory - Empirical

Studies
Patten (1992)
examined the change in the extent of environmental disclosures
of US oil firms around the Exxon Valdez oil spill in Alaska
legitimacy theory suggested that they would increase disclosure
in the annual report after the spill
found the increase in disclosure occurred across the industry

Deegan and Rankin (1996)

used Legitimacy Theory to explain changes in annual report
environmental disclosure policies around proven environmental
prosecutions
prosecuted firms disclosed significantly more environmental
information in the year of prosecution than any other year
prosecuted firms disclosed more information than non-prosecuted
firms

 Legitimacy Theory is different to, but

is aligned with the Political Cost
Hypothesis (PCH) of positive
accounting theory
PCH- Highly visible firms are likely to
adopt accounting methods to reduce
profits to lower political scrutiny

Stakeholder Theory
Considers the relationships that exist between
the organisation and its various stakeholders.
Stakeholders are any group or individual who
can affect or is affected by the achievements of
an organisations objectives
There are two versions of stakeholder theory
a normative theory, known as the ethical branch,
an empirical theory of management, which is a
positive theory

Normative Branch of
Stakeholder Theory
Argues that organisations should
treat all their stakeholders fairly.
An organisation should be managed
for the benefit of all its stakeholders.
Stakeholders are identified, and
should be considered in
organisational decisions because of
their interest in the activities of the
organisation.

Managerial Branch of
Stakeholder Theory
Seeks to explain how stakeholders
influence organisational actions.
The extent to which an organisation
will consider its stakeholders is
related to the power or influence of
those stakeholders.
A stakeholders power is related to the
degree of control they have over
resources required by the organisation.

Role of Accounting Information

in Stakeholder Theory
One important way of meeting
stakeholders needs and expectations is
providing information about organisational
activities and performance. (Annual
Report)
Stakeholder theory has been used to
examine disclosure of voluntary
information to stakeholders, most
commonly relating to social and
environmental performance.

Contingency Theory
Proposes that organisations are all
affected by a range of factors that
differ across organisations.
Organisations need to adapt their
structure to take into account a range
of factors such as
External environment.
Organisational size.
Business strategy.

Contingency Theory
Contingency frameworks have been
used to evaluate management
accounting information and internal
control systems.
They conclude that
There is no universally appropriate
accounting system that can be applied
to all organisations.
Features of appropriate accounting
systems are contingent upon the
specific circumstances the organisation

Using Theories To
Understand Accounting
Decisions

Accountants use judgement to make a

range of accounting decisions on a daily
basis.
Examples include:
Whether to expense or capitalise costs.
What accounting estimates to use.
What, where and how to disclose information.

Theories offer some assistance in

explaining managers and accountants
decisions.

Expensing and Capitalising

Costs
Agency theory would hold that
Managers on compensation contracts which
have bonuses tied to a current measure of
entity performance
Entities with lending agreements with a
leverage covenant,

would prefer to capitalise costs.

Institutional theory would explain the
influence of external norms on
managerial compensation policy.

Accounting Estimates
Agency contracts can explain
managerial decisions in this regard.
Managers and accountants, acting in
self interest, are likely to ensure their
own bonuses are maximised and the
entity is not at risk of breaching debt
contracts.

Legitimacy and stakeholder theory

suggest there are times entities, for
political reasons, will actively reduce
their reported profits.

Disclosure Policy
Disclosure policy relates to additional
disclosure within the annual report or media
releases.
Stakeholder theory would explain these
disclosures in terms of providing relevant
information to maintain relationships with
powerful stakeholders.
Legitimacy theory sees voluntary disclosure as
a way of maintaining or regaining legitimacy by
demonstrating how the entity is meeting
societal expectations.

Next Week
Chapter 6 Products of the financial
reporting process
Chapter 10 - Fair value what is it,
how is it calculated and does it result
in a measure that will result in better
business decisions?