Accounting Theory

1. Earning Management Related to Agency Theory

Earning management is an action used by management to disguise or falsify

the true nature of a company in order to draw customers' attention. Stewardship
relationships between management and investors create a conflict of interest
between shareholders and management in business organizations, which can result
in less ideal management actions. But, the specific individual with stewardship
responsibility is accountable for educating investors. Considering stewardship and
the relationship between the agency and the principal, agency theory explains
management's obsession with earning management. Management of a company
will invisibly prioritize protecting their interests over those of investors at the cost
of the stewardship relationship. According to agency theory, earning management
might bring positive relation and negative relation to a company. If managers see
earnings management primarily as an opportunity, companies with more severe
agency expenses should demonstrate a higher level of earnings management.

On the other hand, earnings management may be meant to disseminate

personal information and therefore improve the informational content for earnings
that would bring advantageous to the stockholders. In this case, managers shouldn't
manage earnings to increase their own personal gains, hence we anticipate that firms
with greater agency costs won't have more earnings management. If earnings
management is beneficial to stockholders, firms with lower agency costs should
exhibit a higher level of earnings management. For example, making a modification
to an accounting procedure that will increase earnings immediately is one way to
manipulate earning and changing corporate policy to require more capitalization of
expenses rather than immediate outlay is another way to control profitability. The
negative relation is an evidence supporting the assumption that the adoption of
earnings management bring advantageous to the company.

By generating a consistent and expanding flow of earnings over time,

management can influence the stock price by giving investors insider information
about their expectations for future prospects. This agency theory demonstrated that
managers will be forced to engage in earning management as measured by a firm's
 performance, which is proxied by its size, profitability, and liquidity. Due to
managers' greater access to information than shareholders, the agency relationship
causes an information asymmetry issue. This will make it possible for managers to
pursue their own interests, such as changing the company's reported earnings to
meet or exceed earnings targets. Actually, managers shouldn't manage earnings to
increase their own interest because organizations with greater agency costs
shouldn't show better earnings management.

The lack of a correlation between earnings management and the severity of

agency costs would indicate that enterprises did not employ earnings management
strategically. When shares are broadly distributed as opposed to when they are
owned by one individual, the agency conflict that results from the separation of
ownership and control may be more significant. Therefore, managers can lessen
agency conflicts with shareholders by voluntarily disclosing information.
According to the agency theory, annual reports are a key source of information for
shareholders who are unable to make significant financial commitments in order to
learn about managers' opportunistic behaviour. Managers of companies with diffuse
ownership are therefore motivated to improve the quality of disclosure in order to
help shareholders in monitoring their actions.

Monitoring are the costs associated with holding management accountable

to shareholders through accounting reports, audits, good corporate governance,
including a comprehensive audit. Audit type serves as yet another proximate for
agency expense. Actually, Bonding expenses have a much bigger role in solving
the agency issue than monitoring costs do. These are the costs of relating managers
to shareholders in a way that helps them see the shareholders' interests as being
identical to their own. This is accomplished by providing the managers with an
adequate number of shares and stock options, as well as by directly linking their
annual bonuses to profits. As a result, these bonding agents have a much greater
impact on the income and wealth of the managers than do their base pay and fringe
benefits. Agency cost is the amount of monitoring charges and bonding costs.

2. Theory in Accounting
There are many theory that are significant to accounting. However, there are two
theory that according to me is more important than the others which are as below:
a. Agency Theory

The idea of agency theory is utilized to clarify and address issues in the
interactions between principals and their agents. In a specific business transaction,
the agent is required to represent the principal's interests in the best possible light,
putting the principal's needs ahead of their own. According to agency theory,
managers run today's businesses while shareholders control them, and their
respective economic interests are not the same. The shareholders are recognized as
the principals, and managers are recognized as their agents. As owners, the have the
right to see their continuously increasing dividend rates, earnings that are sustained
and growing, and profits that are sustained and growing as well. It is assumed that
managers view the desires of shareholders as limitations on their own desires, which
may include the best standard of living conceivable supported by extremely high
compensation.

The agent principal relationship's potential for complexity is shown by the

agency notion. According to this theory, there is a divergence between manager and
owner interests when ownership and control are separated. Agency theory is built
on the premise that managers work to advance their own personal goals
notwithstanding conflicts of interest between them and investors or stakeholders.
For example, in corporations, the shareholders of a company act as the principals
and appoint the management of the company as the agent to carry out their
instructions. According to agency theory, self-interest drives both parties. Agency
theory is subject to eventual conflicts by nature of the self-interest premise.
Therefore, if self-interest drives both parties, it is possible that the agents will pursue
personal interests that diverge from or even oppose the principal's goals. However,
agents have a duty to operate only in the best interests of their principals.

Usually, shareholders make decisions based on logic in order to maximize

their own benefit. Some authors contend that shareholders primarily rely on audited
information to close the information asymmetry gap. Because they stand to lose
more from reputational harm, a major audit firm has a strong motivation to uphold
its independence and implement stricter disclosure requirements. Compared to
small audit companies, the large audit firms invest more to preserve their standing
as reliable control suppliers. They believe that the information will be more accurate
and comprehensive the higher the auditor's caliber.

Additionally, the existence of a sizable audit firm is taken into account as

an indicator of the company's disclosure and the accuracy of its financial data. The
agency theory states that a corporation with a greater debt ratio is compelled to
provide more information. In certain circumstances, empirical evidence doesn't
seem to be conclusive. While every researcher has discovered a link between
leverage and earning quality that is favorable, many others have not. On the other
side, researchers discovered a negative correlation between leverage and disclosure,
indicating that highly leveraged businesses might reveal confidential information to
their creditors that isn't necessarily reflected in their annual reports. These
contradictory findings offer real motivation for future research into this relation. As
a result, the study predicted that there is a negative association between earning
management and leverage. So, Agency Theory is intended to enable businesses to
fulfill needs that are outside of their area of expertise through third parties (Agent)
who are qualified to do so.

b. Positive Accounting Theory

Positive accounting theory aims to explain and predict why a firm's
management and employees select a specific accounting technique over
alternatives. Despite the fact that positive accounting theory is neither
normative and without any other overarching story, critical accounting
researchers have disputed the idea that it is neutral or objective. This theory tries
to explain experiential accounting occurrences by looking at the causes of those
events and it is highly conceiveable that they will manipulate the information in
oreder to gain benefit for themselves. According to positive accounting theory,
a company's management will select from among the legal accounting options
to present the appearance they wants to express to the investing public. There
are three potential events that will have a particular impact on the image:
- The percentage of bonuses based on corporate earnings included in
managerial compensation
- The amount owed by the business, as well as how close its debt is to its
assets, earnings to the targets and ceilings established by the loan
agreement's restrictive covenants, which the lenders impose
- The degree to which a firm considers the political, public relations, or
litigation risks to be high enough that significant claims could be brought
against it for an alleged conduct or omission
According to this theory, the records will be modified to make the present
earnings appear as large as feasible within the legal bounds, the accounting
system, and the auditor's tolerance when managers' own compensation is largely
made up of bonuses depending on the firm's earnings. As a result, accumulated
costs and allowances will be limited and ending inventory will be high in
comparison to the ratio of inventory to sales last year. All of these accounting-
compliant, legal manipulations raise the firm's reported earnings while
remaining within the limits of the rules. The magnitude of the profits gap, which
is predetermined in the managers' contracts, determines the maximum amount
of bonuses that can be paid to managers when earnings fall below a minimum
level. Managers have a motivation to modify reported accruals to show the
highest feasible total because of the bogey and the cap. The accounts will
nevertheless accurately reflect the firm's current economic condition because all
of these changes included actual items. Managers are not always encouraged to
raise their wages through a bonus plan. Managers have an incentive to decrease
earnings this year if earnings fall below the threshold necessary for the payment
of a bonus.
For example, According to positive accounting theory, companies would
manipulate their reported earnings upward if bonuses make up a significant
portion of the compensation for directors or if lenders have set dividend payout
ratio restrictions on the company as a requirement of the loan. According to the
Modigliani and Miller theories of financial economics, many other factors, such
as the impact of tax regulations, are equivalent, therefore the overall share value
is unaffected by a company's level of debt or dividend payout ratio. These
positive accounting theory provide an explanation, a description, and
predict behavior.
 REFERENCES

Donleavy, G. (2016). Gabriel Donleavy An Introduction to Accounting Theory.

Yimenu, K. A., & Surur, S. A. (2019). Earning Management: From Agency and Signalling
Theory Perspective in Ethiopia. Journal of Economics, Management and Trade,
September, 1–12. https://doi.org/10.9734/jemt/2019/v24i630181

https://www.investopedia.com/terms/a/agencytheory.asp