Chapter 3

THEORIES OF FINANCIAL
ACCOUNTING
Objectives of this lecture
1. Be able to describe various normative and positive theories of financial accounting

2. Be aware of some of the limitations of the various theories of accounting

3. Appreciate that there is no single unified theory of accounting

4. Understand the various pressures and motivations that might have an effect on the methods of
accounting selected by an organisation

5. Understand what is meant by ‘creative accounting’ and why it might occur

Why do we bother discussing theories when
we are studying financial accounting?
It is useful to discuss the requirements of the various accounting standards—as we have done in
depth in previous weeks—but that it is also important to provide and understand the frameworks
— so we consider the implications of organisations making particular accounting disclosures,
whether voluntarily or as a result of a particular mandate/regulation

It is useful to consider the various pressures, many of which are political in nature, that influence
the accounting standard-setting environment
Why do we bother discussing theories when
we are studying financial accounting?
Because the impact of financial accounting resonates throughout society it is important to
understand the possible implications of an organisation making particular accounting choices
and disclosures

Theories also provide us with the basis for understanding the various pressures that drive
organisations to make particular disclosures, even in the absence of disclosure requirements
pertaining to particular transactions and events – voluntary disclosure

By covering the material in this lecture, students will hopefully gain a greater the understanding
of the implications of various accounting standards and other disclosure requirements (the
development of thinking accountants! – why do we do what we do?)
Theory definition—what is a 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)
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
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
 Positive Accounting Theory (PAT)
(cont.)
PAT was developed, in part, from another theory known as agency theory. Agency theory discusses agency
relationships, problems and costs.

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. They would include
◦ Monitoring costs
◦ Bonding expenditures
◦ Residual loss
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.
Positive Accounting Theory (PAT)
(cont.)
PAT predictions

To try to improve efficiency, organisations will seek to put in place mechanisms to align the
interests of managers of the firm (the agents) with the interests of the owners (principals)

Some of these mechanisms rely on the output of the accounting system:

◦ For example, owners might agree to pay a manager a bonus based on a specified
percentage of profits
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
◦ 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
◦ Voluntary audits might be undertaken to reduce the perceived risks of investors
◦ Referred to as ex ante perspective
Positive Accounting Theory (PAT)
(cont.)
Efficiency perspective of PAT (cont.)
◦ Accounting methods adopted by firms best reflect the underlying financial
performance of the entity—might select the most efficient way to portray the
performance of the entity
◦ Regulation is, therefore argued by PAT advocates, to impose unwarranted costs on
reporting entities—it causes the firm to provide an inefficient perspective of the
performance and position of the organisation as it requires movement to a one-size-
fits-all approach to reporting
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
◦ 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
◦ Assumes managers will opportunistically select accounting methods to increase their own
personal wealth
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
Positive Accounting Theory (PAT)
(cont.)
Owner/Manager contracting (cont.)

Methods of reducing agency costs of equity

– 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
Positive Accounting Theory (PAT)
(cont.)
Bonus schemes

Remuneration based on the output of the accounting system

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

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

Contracts may rely on ‘floating’, generally accepted accounting principles

Positive Accounting Theory (PAT)
(cont.)
Incentives to manipulate accounting numbers

Rewarding managers on the basis of accounting profits can induce them subsequently 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—so
also common to find the use of share-based reward structures, which in certain circumstances
might be deemed to be more efficient
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

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
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

Some research indicates that the greater the separation between managers and owners, and the
greater the reliance on external debt (meaning greater potential agency costs), the greater the
likelihood that voluntary financial statements audits would be undertaken
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

Positive Accounting Theory (PAT)
(cont.)
Debt contracting

Agency costs of debt:

◦ excess dividends
◦ claim dilution
◦ asset substitution
◦ investment in risky projects

When discussing the agency costs of debt, it is assumed that the managers’ interests are aligned
with the shareholders’ interests
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 bank loan contracts

Monitoring
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
Positive Accounting Theory (PAT)
(cont.)
Political costs (cont.)

Demands placed on the firm might be affected by accounting results

◦ 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

There will be a perception that highly profitable organisations can ‘afford’ to pay higher salaries,
higher taxes, reduce prices—so if firms reduce ‘profits’ such expectations might decrease
Positive Accounting Theory (PAT)
(cont.)
Ways to reduce political costs

Management might:
◦ adopt income-reducing accounting techniques
◦ make voluntary social disclosures
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

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

So, in considering the usefulness of PAT, how might auditors utilise the above hypotheses/predictions when
undertaking a financial statement audit?
PAT in summary
Selection of accounting methods can be explained by either efficiency or opportunistic arguments
◦ So the theory provides insights into why managers favour particular accounting methods in preference to others

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

◦ For example, might ‘loosen debt covenants’ but increase political costs

Emphasises the way in which accounting numbers are actually used throughout society and how a change
in accounting methods can have implications for relationships with managers, debtholders, and the
broader political environment
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.
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
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

- makes recommendations that sometimes depart from current practice

Normative accounting theories (cont.)
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

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)
Normative accounting theories (cont.)
Exit-price accounting

Continuously contemporary accounting

Uses exit or selling prices to value the entity’s assets and liabilities
◦ Referred to as current cash equivalents

Assumptions
◦ 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
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:

◦ the net selling price
◦ the present value of future cash flows
◦ an asset’s current replacement cost
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
◦ Institutional Theory
The
organisation
viewed as part
of a wider
social system
 Systems-oriented theories (cont.)
Stakeholder theory

Two branches
1. Ethical (normative) branch
2. Managerial (positive) branch

1. Ethical (normative) branch

◦ 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
◦ All stakeholders have a right to be provided with information
 Systems-oriented theories (cont.)
Stakeholder Theory (cont.)
1. Ethical (normative) branch (cont.)
◦ Because it prescribes how stakeholders should be treated (based on various ethical
perspectives), it is a normative approach and is based on various ethical perspectives
◦ Under this perspective, information should be provided because of various ‘rights-to-know’

2. Managerial (positive) 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
Systems-oriented theories (cont.)
Managerial branch (cont.)
◦ Financial and social information is used to control conflicting demands of various stakeholder
groups
◦ Management will respond to the information demands of stakeholders perceived as being
powerful
◦ From this perspective, if a stakeholder group does not have power then their information
demands might not be met
◦ Information disclosure is strategic
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,

Where this social contract is perceived as being breached then the organisation will take
corrective action, and this action might include 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 (and a number of studies are referred to in the textbook) 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 ‘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

Two main dimensions to the theory—isomorphism and decoupling

 Systems-oriented theories (cont.)
Institutional Theory (cont.)

Isomorphism
◦ coercive
◦ mimetic
◦ normative

Decoupling
◦ Actual practices can be very different from formally sanctioned and publicly pronounced processes
and practices
◦ Disclosures might not actually represent real corporate conduct
◦ Such theories caution us against ‘believing’ everything we are told (including within financial reports)
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
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.

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).
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 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.
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,
◦ relies upon a fundamental assumption that individual action can be predicted on the basis that
all action is driven by a desire to maximise wealth (a perspective often criticised by other
researchers).
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, current-cost accounting, exit-price accounting and
deprival-value accounting.
Summary (cont.)
Systems-based theories

Include Stakeholder Theory, Legitimacy Theory and Institutional 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 and particular organisational forms 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.
Summary (cont.)
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,

• 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 into accounting issues.