1. GODFREY HODGSON HOLMES TARCA
CHAPTER 11
POSITIVE THEORY OF ACCOUNTING POLICY AND DISCLOSURE

2. Early demand for theory
Capital markets research tried to explain the effects of accounting
was ultimately inconclusive and inconsistent
mechanistic and no-effects hypotheses
This research relied upon the EMH
ultimately there were too many departures
Led to the development of a positive theory of accounting policy choice

3. Early demand for theory
Positive theory incorporated a number of observations
many firms voluntarily provided accounting reports
firms lobbied in relation to accounting standards
firms made consistent policy choices
firms tended toward conservatism

4. Contracting theory
The firm is seen as a ‘nexus’ of contractual relationships
The firm is seen as an efficient way of organising economic activity to reduce contracting costs
equity (management) contracts (an agency contract)
debt contracts (an agency contract)

5. Agency theory
An agency contract is one where one party (the principal) engages another (the agent) to act on their behalf
e.g. where there is a separation of management and ownership
Both parties are utility maximisers
agent may therefore act from self-interest
divergence of interests is the agency problem
contracts incorporating accounting numbers can be used to align the interests of both parties

6. Agency theory
The agency problem in turn gives rise to agency costs spent to overcome it
monitoring costs
bonding costs
residual loss

7. Agency theory
Monitoring Costs – the cost of monitoring the agent’s behaviour; initially borne by the principal but passed on to the agent through an adjustment to their remuneration (price protection)
auditing costs, operating rules…
Bonding Costs – the cost borne by the agent as a result of them taking action to align their interests with those of the principal
providing more regular financial reports (a cost to the manager in terms of time and effort)
constraints on their activities…

8. Agency theory
The agents incur bonding costs in order to reduce the monitoring costs they eventually bear
Agents stop spending on bonding costs when the marginal cost equals the marginal reduction in the monitoring costs they bear
$1 = $1

9. Agency theory
Residual Loss – the loss associated with not being able to fully align the interests of the agent with those of the principal
Ex post settling up – (ex post = at the end of each period)
agent’s future remuneration based on observed agent performance
the principal changes the remuneration to be paid to the agent to align it with their performance

10. Agency theory
In the real world, price protection and settling up are not perfect or complete
Agents perceive that they will therefore not be fully penalised for their divergent behaviour
They have incentives to act opportunistically
This increases the residual loss
This loss is borne by the principal as well as, or instead of, the agent

11. Agency theory Agency theory attributes a role for accounting
Accounting is part of the monitoring and bonding mechanisms
Accounting numbers are used in contracts

12. Price protection and shareholder/manager agency problems
The separation of ownership and management leads to divergent behaviour by agents
Divergence comes about because of
the risk-aversion problem
the dividend-retention problem
the horizon problem

13. Price protection and shareholder/manager agency problems
Risk aversion
managers prefer less risk than do shareholders
different degrees of diversification affecting risk
limited liability accorded to shareholders

14. Price protection and shareholder/manager agency problems
Dividend-retention
managers prefer to pay out less of the profits as dividends than shareholders prefer
pay their remuneration
empire building

15. Price protection and shareholder/manager agency problems
Horizon
managers have a shorter time horizon with respect to their association with the firm than do shareholders
shareholders are interested in future cash flows
managers have a time horizon only as long as they intend to remain with the firm

16. Price protection and shareholder/manager agency problems
Contracting can be used to reduce the severity of these problems
manager remuneration is usually tied to firm performance in some way to motivate managers to act in the shareholders’ interest
performance can be related to accounting numbers such as sales, profits, return on assets, net asset growth, cash flow, etc
performance can be related to the firm’s share price

17. Shareholder-debtholder agency problems
In this context, the manager is assumed to be either the sole owner of the firm, or has interests that are totally aligned with the interests of the shareholders
the principal is the debtholder
the agent is the manager acting on behalf of shareholders

18. Shareholder-debtholder agency problems
Firm value is the value of debt plus the value of equity
The value of equity can be increased by
either increasing the value of the firm (efficient contracting); or
transferring wealth away from debtholders (opportunistic behaviour)

19. Shareholder-debtholder agency problems
Varieties of opportunistic behaviour
excessive dividend payments
asset substitution
underinvestment
claim dilution

20. Shareholder-debtholder agency problems
Excessive dividend payments
reduces the asset base securing the debt
shareholders have received cash but limited liability protects them from being personally liable for the debts of the firm in the event of bankruptcy
the debt becomes mispriced
reduces the value of the debt

21. Shareholder-debtholder agency problems
Asset substitution
firm invests in higher risk projects to benefit shareholders
no benefit to debtholders
but do share in possible losses
shareholders are able to diversify and have limited liability
debt becomes mispriced

22. Shareholder-debtholder agency problems
Underinvestment
in some circumstances, shareholders have incentives not to undertake positive NPV projects because to do so would increase the funds available to the debtholders but not to the shareholders

23. Shareholder-debtholder agency problems
Claim dilution
occurs when the firm issues debt of a higher priority than the debt already on issue
decreases the relative security and value of the existing debt

24. Shareholder-debtholder agency problems
Lenders will price protect
through interest rates, the withholding of funds and the length of the loan
The interests of shareholders can be bonded to those of debtholders via restrictions in lending agreements
loan covenants

25. Ex post opportunism versus ex ante efficient contracting
occurs when, once a contact is in place, agents take actions that transfer wealth from principals to themselves

26. Ex post opportunism versus ex ante efficient contracting
occurs when agents take actions that maximise the amount of wealth available to distribute between principals and agents
ex ante – before contracts are finalised

27. Signalling theory
Managers voluntarily provide information to investors - signals - to assist in their decision making
Similar to efficient contracting
Aligned with the information hypothesis
Managers signal expectations and intentions regarding the future
Incentives to signal good, neutral and bad news

28. Political processes
Often firms try to avoid public attention that is costly to them
financially
in terms of public perception and reputation
They reduce their reported profit or its volatility
e.g. banking sector in Australia

29. Conservatism, accounting standards and agency costs
Conservatism shows a bias by accountants accelerating recognition of expenses and decelerating recognition of revenue
IASB argues this does not reveal the real financial picture and reduces information available to users

30. Additional empirical tests of the theory
Testing the opportunistic and political cost hypothesis
Tests using contract details
Refining the specification of political costs
Testing the efficient contracting hypothesis

31. Additional empirical tests of the theory
Evidence that managers use accounting numbers to
counter political pressure
gain political advantages
set management targets related to remuneration
minimise breaching debt covenants
provide dividend constraints
constrain management manipulation

32. Evaluating the theory Mixed support for positive accounting theory
Two categories of major criticism
methodological and statistical criticism
empirical evidence is weak and inconclusive
philosophical criticism
contrary to its claims, it is laden with value judgments
focuses on human behaviour and not the behaviour and measurement of accounting entities
positivism is no longer taken seriously

33. Issues for auditors
The demand for auditing can be explained by agency theory as part of the monitoring and bonding activity and costs
higher quality auditors
industry specialist auditors

34. Summary
Positive accounting theory has been a major force in academic accounting research
Incorporates a theoretical model of contractual exchange between persons who use accounting numbers to effect their payoffs
Provides an explanation as to why accountants account as they do
minimises the cost of agency relationships
yet opportunistic behaviour by agents is the norm
but some efficient ex ante behaviour by agents

35. Key terms and concepts Positive theory Contracting theory
Agency theory
Agents
Principals
Monitoring costs
Bonding costs
Residual loss
Ex post settling up
Risk aversion problem
Dividend retention problem
Horizon problem

36. Key terms and concepts Shareholder/manager agency problem
Shareholder/debtholder agency problem
Excessive dividend payment problem
Asset substitution problem
Underinvestment problem
Claim dilution problem
Ex post opportunism
Ex ante efficient contracting
Signalling theory
Political processes
Conservatism