Topic 1A

Theories of financial
accounting
References:
Deegan 9th Edition Chapter 3
Cloudfirst resources available on the unit site

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 Learning objectives

1. Explain various normative and positive theories of financial

accounting
2. Explain various pressures and motivations that might have an effect
on the methods of accounting selected by an organisation.
3. Describe the choice of alternative accounting policies that can be
explained from either an ‘efficiency perspective’ or from an
‘opportunistic perspective’
4. Discuss the basic tenets of Stakeholder Theory, Legitimacy Theory,
and Institutional Theory as they can be applied to explaining
accounting practice.
5. Describe theories that explain why regulation—such as an accounting
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regulation—is introduced.
 Overview of lecture

This lecture provides an overview of the following four broad areas of

accounting theory and research:

1. Normative theories of accounting

2. Positive theories of accounting
3. Systems-oriented theories explaining accounting practice
4. Accounting theory related to regulation

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 What is an Accounting Theory?

• Theory
– A coherent group of propositions or principles forming a general
framework of reference for a field of inquiry
• Accounting theories—and there are many—often:
– explain and predict accounting practice (referred to as positive
theories) or
– prescribe particular practice (referred to as normative theories)

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 Positive Accounting Theory (PAT)

• The first theory we shall describe is Positive Accounting Theory

(popularised by Watts and Zimmerman)
• Positive Accounting Theory is an example of a positive theory of
accounting
• PAT explains and predicts accounting practice
• PAT does not seek to prescribe particular actions

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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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 Positive Accounting Theory (PAT) (cont.)

What is PAT’s focus?

• PAT focuses on the relationships between the various individuals involved in
providing resources to an organisation:

1. Between owners (as suppliers of equity) and managers (as

suppliers of managerial labour)

2. Between managers and the firm’s debt providers

Many relationships involve the delegation of decision making from one party
(the principal) to another party (the agent), referred to as an agency
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relationship.
 Positive Accounting Theory (PAT) (cont.)

Agency relationships and costs

• The delegation of decision-making authority by the principal (the owner)

to the agent (the manager) can lead to a loss of efficiency and,
consequently, increased costs.

• Any loss of profits brought about because the manager underperforms is

a cost of decision-making delegation within this agency relationship, that
is, an agency cost of equity.

• Accordingly, PAT investigates how particular contractual arrangements can

8 be put in place to minimise agency costs.
 Positive Accounting Theory (PAT) (cont.)

Agency relationships and costs (cont.)

• PAT predicts organisations seek to put into place mechanisms that align
the interests of the managers of the firm (the agent) with the interests
of the owners of the firms (the principals).

• Where such accounting-based alignment mechanisms are in place,

financial statements will need to be produced (i.e., bonding costs).

• PAT also predicts that where financial statements are required to be

produced, there is demand for those statements to be audited or
monitored (i.e., monitoring costs).

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 Positive Accounting Theory (PAT) (cont.)

Agency relationships and costs (cont.)

• PAT assumes that not all the opportunistic actions of agents can
be controlled by contractual arrangements or otherwise, there
will always be some residual costs associated with appointing
an agent (i.e., residual loss).

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Positive Accounting Theory (PAT) (cont.)

Efficiency and opportunistic perspectives of PAT

Efficiency perspective

• PAT explains how various contracting mechanisms can be put in place to minimise the agency costs of the firms.

• The efficiency or ex ante (‘before the fact’) perspective considers what mechanisms are introduced up front by
the firm to minimise 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.

• The ex-ante or efficiency perspective also argues that accounting practices adopted by firms underlie the
financial performance of the entity.

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Positive Accounting Theory (PAT) (cont.)

Efficiency perspective of PAT (cont.)

PAT argues that regulation of financial accounting imposes
unwarranted costs on reporting entities

For example, an imposed new accounting method via an

accounting standard or regulation is likely to lead to an
increase in the firm’s costs

PAT argues that management is best able to select which

accounting methods are appropriate in given circumstances, and
government should not intervene in the process.

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 Positive Accounting Theory (PAT) (cont.)

Opportunistic perspective

• In contrast to the efficiency perspective, PAT seeks to explain and predict certain
opportunistic behaviours that will subsequently occur (i.e., ex post or ‘after the
fact’) 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 (i.e., 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.

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Assumes managers will opportunistically select accounting methods to increase their
own personal wealth
 Positive Accounting Theory (PAT) (cont.)

Owner/Manager contracting

•All action taken by an individual is driven by self-interest, and that the

major interest of all individuals is to maximise their own wealth (rational
economic assumption).

•Accordingly, owners (principals) would expect managers (agents) to

undertake activities that might not be in the best interests of the owners.

•Managers will have access to information that is not available to

principals (information asymmetry), thus increasing the potential for
managers to take actions that are beneficial to themselves at the expense
14 of the owners (agency costs).
 Positive Accounting Theory (PAT)
(cont.)

Owner/Manager contracting (cont.)

• As principals assume that agents will be driven by self-interest,

principals will price this into the amounts they are prepared to pay
managers.

• This lower salary compensates the principals for, or protects them

from, the expected opportunistic behaviour of the agents, and
managers thus bear some of the agency costs of the opportunistic
behaviours.

 Managers may be rewarded:

• on a fixed basis
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• on the basis of the results achieved
• on a basis that combines the two
 Positive Accounting Theory (PAT) (cont.)

Bonus schemes

• Remuneration based on the output of the accounting system

 Put in place to align the interests of managers with the owners.

• Very common to find accounting-based remuneration structures and

their existence can be explained by PAT

• Bonuses might be based on:

 profits of the firm
 sales of the firm
 return on assets
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• May also be rewarded based on market price of shares
 Positive Accounting Theory (PAT) (cont.)

Accounting-based bonus schemes

• Any changes in the accounting methods used by an organisation

will affect the bonuses paid (e.g. as a result of a new accounting
standard).

• Changing the bonuses paid impacts on cash flows, and this in turn
is predicted to impact on the value of the organisation.

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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 related
rewards.

 For example, managers might manipulate accruals

• Research (e.g., Healy, 1985; Holthausen et al., 1995) has found that when schemes
exist that reward managers after a pre- specified level of earnings had been reached,
managers will adopt accounting methods consistent with maximising that bonus.

• Similarly, rewarding managers on the basis of accounting profits might discourage

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them from adopting investment strategies that maximise the present value of the
firm’s resources (i.e., short-term versus long-term focus)
 Positive Accounting Theory (PAT) (cont.)

Market-based bonus schemes

• Alternatively, managers approaching retirement could be rewarded in

terms of market-based schemes such as:

– Basing a cash bonus on any increases in share prices

– Providing managers with shares or option to shares in the firm

If the value of the firm’s shares increases, both managers and

owners will benefit and, importantly, managers will be given an incentive
to increase the value of the firms.

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 Positive Accounting Theory (PAT) (cont.)

Limitations market-based bonus schemes

• Share price is not only affected by factors controlled by managers

but also by outside, market-wide factors

• Only senior managers would likely to have a significant effect on

the cash flows of the firm and, hence, the value of the firms’
securities.

• Offering shares to lower management might be demotivating, as

their own individual actions would have little likelihood , relative
to senior management, of affecting share prices

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Positive Accounting Theory (PAT) (cont.)

Debt contracting

When a party lends funds to another organisation, the recipient of

the funds might undertake activities that reduce or even eliminate
the probability of the funds being repaid, leading to what is known
as agency cost of debt

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 Positive Accounting Theory (PAT) (cont.)

Examples of agency costs of debt are:

• Recipients of funds might pay excessive dividends, leaving few

assets in the organisation to service the debt.

• Recipients of funds might take on new debt, leaving original debt

holders to compete with new debt holders for
repayment, resulting in a ‘claim dilution’ problem (Smith &
Warner, 1979).

• Recipients of funds might also invest in high-risk projects which

might fail leaving the debt holder with no repayment.
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 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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Positive Accounting Theory (PAT) (cont.)

• Debt covenants create incentives to manipulate accounting number

– Evidence indicates that if firms are close to breaching accounting-based
debt contracts (such as debt to asset constraints, or interest coverage
requirements) then managers are more likely to opportunistically adopt
particular accounting methods

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 Positive Accounting Theory (PAT) (cont.)

Political costs

-Political costs refer to the costs that particular groups external to the firm may be able to impose
on the firm, such as costs associated with increased taxes, increased wage claims or product
boycotts.

-Organisations are affected by government, trade unions, environmental lobby groups, consumer
groups, and other interest groups.

-That is, organisations operate within a political environment

-Demands placed on firms by interest groups might be affected by the accounting results of the firm,
such as profits, which might lead to the imposition of additional costs on the firm through increased
taxes, reduction in the prices of products the firm makes, or wage increases.
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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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All this discussion leads to three main hypotheses of PAT
that attempt to explain or predict accounting practice

 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 will be to use
accounting methods that increase income (and assets) and
thereby ‘loosen’ debt covenants

 The political cost hypothesis predicts that large firms (that are
assumed to be subject to high levels of political scrutiny), rather
than small firms, are more likely to make accounting choices
that reduce reported profits
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 Criticisms of PAT

– Does not provide prescription so does not provide a means of

improving accounting practice
– Not value-free but rather is value-laden
– Underlying assumption of wealth maximisation is simplistic
– Issues being addressed have not shown any significant
development
– Scientifically flawed

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 Normative accounting theories

In contrast with positive theories, normative theories:

• seek to provide guidance in selecting accounting procedures

that are most appropriate

• prescribe what should be done

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 Normative accounting theories ( cont.)

The Conceptual Framework:

-is considered a normative theory

-seeks to identify the objective of General-Purpose Financial Reporting

-seeks to provide accounting guidance within a ‘coherent’ and ‘consistent’

framework

-identifies the qualitative characteristics financial information should possess

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- makes recommendations that sometimes depart from current practice

 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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 Systems-oriented theories

• An entity is assumed to be influenced by the society in which it

operates and in turn to have an influence on society

• Systems-oriented theories explain the role of information and

disclosure in managing the relationship between an organisation
and the communities within which it interacts.

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The organisation viewed as part of a wider social system

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 Systems-oriented theories (cont.)

• Accounting disclosure policies are considered to constitute a

strategy to influence or manage the relationships between the
organisation and other parties with which it interacts, and these
strategies are explained in the following 3 approaches:

 Stakeholder theory

 Legitimacy theory

 Institutional theory

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 Systems-oriented theories (cont.)

Stakeholder theory

• This theory considers the importance for an organisation’s

survival of satisfying the demands of its various stakeholders

• Stakeholders can be “any group or individual who can affect or is

affected by the achievement of the firm’s objectives”
(freeman, 1984), e.g., Shareholders, employees, customers,
etc.

• Stakeholder theory has both an ethical (‘normative’) and a

managerial (‘positive’) aspect

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 Systems-oriented theories (cont.)

Stakeholder Theory (cont.)

1. Ethical (normative) branch

• believes that all stakeholders have intrinsic rights (.e.g., safe-

working environment) and these rights are inviolable.

• all stakeholders have a right to be provided with information

about how the organisation is affecting them, even if they choose
not to use the information.

• As the ethical view espouses normative views about how the

organisation should act towards their stakeholders, this
perspective cannot be validated by empirical observation.
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 Systems-oriented theories (cont.)

Stakeholder Theory (cont.)

2. Managerial (positive) branch

• to explain and predict how organisations will react to demands of

various stakeholder groups

• Relative power and importance of stakeholders is considered —

associated with ongoing operations and control of resources

• Relative power and importance can change across time

• The firm will take actions to ‘manage’ its relationships with these
more powerful and important stakeholders.
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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 organization

• Where this social contract is perceived as being breached then the

organisation will take corrective action, and this action might include
38 disclosure
 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

• Research using this theory shows that when the legitimacy of an

organisation is threatened (perhaps as a result of a particular incident
or event) managers will use information disclosure to try to maintain
or regain legitimacy.

• Disclosures are linked to corporate survival rather than to

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‘accountability’
 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.

• Under this theory organisations adopt particular practices—

including disclosure practices—because doing so provides legitimacy.

• Particular practices might be adopted despite the fact they are not
necessarily the most efficient practices.

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 Theories explaining why regulation is
introduced
• Just as there are theories to explain why particular accounting
disclosures are made (e.g. PAT, Legitimacy Theory, Stakeholder Theory),
or why particular organisational forms exist (Institutional Theory), there
are also theories to explain why particular regulations (e.g. accounting
regulations) are developed. Such theories include:

 Public interest theory

 Capture theory
 Economic interest group theory

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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 and not motivated by

self-interest

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 Theories explaining why regulation is
introduced (cont.)

Capture theory

• While regulations might initially be introduced in the ‘public

interest’, the regulated parties will seek ultimately to take charge of
(or capture) the regulator.

• They will seek to ensure that rules subsequently released are

advantageous to themselves (the parties subject to the regulation).

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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

• If regulators believe that particular regulation will provide economic

benefits to themselves (the regulators) then they will support that
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regulation
 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

• 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

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Summary

• The lecture 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
– for example, 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
• Normative theories of accounting
– Prescribe how accounting should be practised
– Argue typically that a central role of accounting theory is to provide prescription
46 —inform about optimal accounting approaches and why a particular approach is
considered optimal
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Summary

• Systems-based theories
– Include Stakeholder Theory, Legitimacy Theory and Institutional Theory
• Sees organisations as firmly embedded within a broader social system
• Organisations are considered to be affected by, and to affect, the societies in
which they operate
• Theories that seek to explain how regulation is developed
– Some theories (Public Interest Theory) 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
47 – Overall, the selection of one theory over another will depend on the views and
expectations of the researcher in question
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