5/20/2022

110.309
ADVANCED FINANCIAL ACCOUNTING

Week 11
Accounting Theories

Reading:
Deegan Ch.3

Learning Objectives
Be able to:
• Identify/describe some key
• normative, and
• positive accounting theories
• Explain why accounting theories are useful;

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THEORY PAT SYSTEMS-

POSITIVE ORIENTED REGULATION
NORMATIVE

Some Normative accounting theories

Conceptual Framework (most recent)
?

Current-cost accounting (e.g., replacement cost)

Aim is to provide a calculation of income that, after adjusting for changing prices, can be withdrawn from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 income’

Exit-price accounting (Continuously contemporary accounting or CoCoA)

Aim is to inform users of ‘capacity to adapt’. Uses exit or net selling prices to value assets and liabilities
- The value of this ‘capacity to adapt’ is referred to as ‘current cash equivalents’
Assumptions
• Firms exist to increase the wealth of their owners
• Success/wealth depends on ability to adapt to changing circumstances
• Capacity to adapt is best reflected by current selling prices

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Some Normative accounting theories

Deprival-value accounting
Aim is to represent the loss that might be incurred by an entity if deprived of the use of an asset and the
associated economic benefits
Assumptions:
Deprival value of an asset = lower of:
• current replacement, and
• Higher of: (net selling price) v (PV of future cash flows)

Positive Accounting Theory (PAT)

• Developed by Watts and Zimmerman in 1970’s
• Focuses on relationships between various individuals involved with a firm:
• Owners and managers, and
• Managers and debt providers, and
• External stakeholders
• Grounded in economic theories – Agency; Contracting; Theory of the Firm
• Firms are subject to various costs including:
• Agency costs (monitoring, bonding and residual costs), and
• Political costs
• They try to minimize these costs (overall) by efficient contracting
• Contracts use accounting numbers i.e., influenced by accounting methods
• So, accounting choices have consequences - affect wealth/wealth transfers
• Leads to motivations/incentives explained in terms of 3 main hypotheses

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Positive Accounting Theory (PAT)

Key Assumptions
• All individual action is driven by self-interest; no loyalty or morality effects (is this realistic?)
• Information asymmetry – managers have access to information not available to owners
• Individuals will act in an opportunistic manner to increase their wealth (wealth transfers)
• Firms are seen as a collection of self-interested individuals who cooperate if it is in their interest

Efficiency perspective
Mechanisms are put in place ‘up front’ (ex ante) to align interests (so solve the ‘agency problem’ +
minimise future agency costs) hence increase the size of the ‘pie’ for all parties e.g.,:
• Bonus plans tied to accounting profits, shares or options for managers
Opportunistic perspective
Assumes managers will opportunistically select accounting methods to increase their own personal
wealth, after (ex post) contractual arrangements have been put in place e.g.,
• After bonus plan is in place to motivate managers, they will manipulate profits

Positive Accounting Theory (PAT)

3 main hypotheses attempting to explain or predict
accounting practice/choices:
1. Bonus hypothesis – predicts managers will overstate income to earn bonuses;

2. Debt/equity hypothesis - predicts managers will overstate income/

understate debt as firm’s debt/equity ratio increases;

3. Political cost hypothesis - predicts that large firms (assumed to have higher
levels of political scrutiny) will understate profits

Implications for auditors? Contracting responses?

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PAT – Compensation/Bonus Contracts

Agency problems/ concerns for Owner (Principal)
• Over-compensating managers

Contracting solutions/ Methods of reducing agency costs of managers

• Price protection – lower salary
• Monitoring by owners (incl. use of auditors)
• Bonding by managers – to reduce options for opportunism e.g., prepare F/S
• Managers may be rewarded:
• on a fixed basis
• on the basis of results achieved (e.g., profits, sales, ROA, share price)
• on a basis that combines the two

Pro’s and cons to each contractual response and Residual Costs will always remain

PAT – Debt Contracts

PAT assumes Owner/Manager conflict is resolved, so focus is on Debtholder/Manager conflict
Agency problems/ concerns for Debt holder
• Excess dividends - “borrow and run”
• Asset substitution – “bait and switch” riskier asset
• Claim dilution – “too many creditors”
• Excess risk – taking on projects with too much risk

Contractual Methods of reducing agency costs for Debt holder

• Restrict dividends, specify min profits
• Specify secured assets and restrict large asset sales, takeovers
• Maintain minimum level of equity
• Restrict new debt
• Price protection - higher interest charges to compensate for risk
• Interest cover clauses
• Debt to asset/Leverage clauses
• Monitoring (audit)

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PAT - Political costs

Costs imposed by groups external to the firm e.g.,
• Increased taxes and wage claims
• Product boycotts
• Decreased subsidies/ grants/ export credits/ depreciation allowances
• Price controls
Which external groups?
• government, trade unions, environmentalists, or particular consumer groups
Why?
• Perceptions that highly profitable organisations should pay higher salaries, higher taxes,
reduce prices or that large firms are not paying fair share of tax
Potential responses by management
• adopt income-reducing accounting techniques
• make voluntary social disclosures

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Accounting policy choice

& ‘Creative accounting’
• Accounting policy choice may have significant implications for accounting numbers
(Tourism Holdings and IFRS)
• The 3 PAT hypotheses illustrate the incentives to manipulate accounting numbers
• High profile frauds highlight methods used
• Griffiths (1987) describes some of these methods in his book ‘Creative Accounting’
• Standards have developed since then to restrict such manipulation, but choices still
exist, emphasising importance of:
• Ethics in governance
• Disclosure of accounting policies chosen
• Independent audit opinion – do these result in fair presentation?

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Systems-oriented theories
Focus is on role of information in managing relationships between the firm and society

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Some Systems-oriented theories

Stakeholder theory
• Holds that firm is accountable to all stakeholders not just managers, debt and equity holders
• Ethical (normative) branch - prescribes how stakeholders should be treated on basis of
various ‘rights-to-know’
• Managerial (positive) branch - seeks to explain and predict how an organisation will react
to demands of various stakeholders
• Firm’s reaction seen as strategic – information is disclosed to control conflicting
demands, preferring those of most powerful stakeholders

Legitimacy theory
• Based on concept of a ‘social contract’ with society
• When legitimacy of an organisation is threatened (e.g., oil spill publicity) managers will use
information disclosure to try to maintain or regain legitimacy
• Disclosures are linked to corporate survival rather than to ‘accountability’

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Some Systems-oriented theories

Institutional theory
• Explains why organisations within particular ‘fields’ tend towards similar characteristics/form
• Overlaps with Legitimacy and Stakeholder Theories
• Two main dimensions to the theory—isomorphism and decoupling:
• Isomorphism could be – coercive; mimetic or normative
• Decoupling – warns that actual practices may differ from those formally sanctioned/ dislcosed

Such theories caution us against ‘believing’ everything we are told (including within financial reports)

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Some theories explaining why

Regulation is introduced
Public interest theory
• Regulation is put in place to benefit society as a whole rather than vested private interests
• Assumes that government is a neutral arbiter and not motivated by self-interest

Capture theory
• Regulated parties seek ultimately to take charge of (or capture) the regulator to ensure rules are
advantageous to themselves

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Some theories explaining why

Regulation is introduced
Economic interest group theory
• Assumes groups will form to protect particular economic interests
• The regulator is not a neutral arbiter but is seen as an interest group
• The 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

• No notion of public interest inherent - all groups deemed to be motivated by self-interest

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Conclusion
• No one theory offers a complete solution, explanation or
prediction

• All, however offer potentially valuable perspectives and

deeper insight on accounting issues

• Recap Objectives

• Questions?

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