Deegan5e Ch03

Chapter 3 Theories of financial accounting

Objectives Be able to describe various normative and positive theories of financial accounting Be aware of some of the limitations of the various theories of accounting Appreciate that there is no single unified theory of accounting Understand the various pressures and motivations that might have an effect on the methods of accounting selected by an organisation Understand what is meant by ‘creative accounting’ and why it might occur

Theory definition A coherent group of propositions or principles forming a general framework of reference for a field of inquiry Accounting theories explain and predict accounting practice (positive theories) or prescribe particular practice (normative theories)

Positive Accounting Theory (PAT) Positive Accounting Theory is an example of an example of a positive theory of accounting. As we will see later, there are other positive theories of accounting (as well as normative theories of accounting) PAT Explains and predicts accounting practice 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.) Agency theory 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

Positive Accounting Theory (PAT) (cont.) Agency costs 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 Organisations will seek to put in place mechanisms to align the interests of managers of the firm (agents) with the interests of the owners (principals) Some of these mechanisms rely on the output of the accounting system for example, the owners might agree to pay the 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 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 – 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 (that is, 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 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 the organisation will affect the bonuses paid (e.g. as a result of a new accounting standard) Changing the bonuses paid impacts cash flows, and this in turn is predicted to impact 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

Positive Accounting Theory (PAT) (cont.) Market-based bonus schemes 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 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 Australian 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

Positive Accounting Theory (PAT) (cont.) Ways to reduce political costs Management might: adopt income-reducing accounting techniques make voluntary social disclosures

Discussion leads to 3 main hypotheses of PAT 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 use accounting methods that increase income. The political cost hypothesis predicts that large firms rather than small firms are more likely to use accounting choices that reduce reported profits.

PAT in summary Selection of accounting methods can be explained by either efficiency or opportunistic arguments 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

Accounting policy selection and disclosure To allow comparison between reporting entities a summary of accounting policies must be presented in the notes to the financial report (AASB 101, par. 108) where an accounting policy has changed and the change has a material effect on results the notes must disclose the nature of, reason for, and financial effect of the change (AASB 108, par. 29)

Accounting policy selection and disclosure (cont.) Accounting policy choice and ‘creative accounting’ ‘Creative accounting’ refers to selecting accounting methods that provide the result desired by the preparers Also known as opportunistic Can be explained by PAT It is possible to be creative and still follow accounting standards

Criticisms of PAT Does not provide prescription so does not provide a means of improving accounting practice Not value-free but rather value-laden Underlying assumption of wealth maximisation is simplistic Issues being addressed have not shown any significant development Scientifically flawed

Normative accounting 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 GPFR seeks to provide recognition and measurement rules within a ‘coherent’ and ‘consistent’ framework identifies the qualitative characteristics financial information should possess makes recommendations that depart from current practice

Normative accounting theories ( cont.) Other normative theories Three main classifications current-cost accounting exit-price accounting 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 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

Systems-oriented theories (cont.) Stakeholder Theory Two branches Ethical (normative) branch Managerial (positive) branch 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, etc. all stakeholders have a right to be provided with information because it prescribes how stakeholders should be treated (based on various ethical perspectives), it is a normative approach

Systems-oriented theories (cont.) Stakeholder Theory (cont.) 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.) Stakeholder Theory (cont.) Stakeholder Theory (either branch) does not prescribe what information should be disclosed, other than indicating that the provision of information can be useful for the continued operations of the entity Managerial branch (cont.) financial and social information is used to control conflicting demands of various stakeholder groups

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

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 Isomorphism coercive mimetic normative Decoupling actual practices can be very different from formally sanctioned and publicly pronounced processes and practices

Theories explaining why regulation is introduced Just as there are theories to explain why particular accounting disclosures are made (PAT, Legitimacy Theory, Stakeholder Theory), or why particular organisational forms exist (institutional theory), there are also theories to explain why particular regulations (for example, 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

Theories explaining why regulation is introduced (cont.) Capture theory The regulated seeks to take charge (capture) the regulator They seek to ensure rules subsequently released are advantageous to the parties subject to 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

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 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 chapter 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 e.g. 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 Project, 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 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 in accounting issues

Deegan5e Ch03

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Deegan5e Ch03