1. An overview of theories of accounting Chapter 3
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2. Learning objectives Describe what is meant by theory
Describe what Positive Accounting Theory (PAT) represents:
Understand how accounting’s outputs are used in contracts
To explain why selection and disclosure of accounting policies is important
Understand what ‘creative accounting’ is
Consider criticisms of PAT
Describe accounting theories
Normative accounting theories
System orientated accounting theories
Theories of regulation
Critical theories
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3. Theory definition
‘a coherent set of hypothetical, conceptual and pragmatic principles forming the frame of reference for a field of inquiry’
Accounting theories fall into two broad categories:
Positive theories
explain and predict accounting practice.
Normative theories
prescribe practice.
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4. Positive accounting theory (PAT)
Explains and predicts accounting practice.
Does not seek to prescribe particular actions.
Grounded in economic theory.
Focuses on relationships between resource providing individuals and their organisations (agency relationship):
Owners and managers
Managers and debt providers.
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5. Positive accounting theory (PAT)
Agency theory:
The agency relationship
Delegation of decision making from the principal to the agent.
The 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
Monitoring costs
Bonding expenditures
Residual loss.
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6. Positive accounting theory (PAT)
Assumptions of PAT:
Individual action is driven by self-interest.
Individuals 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.
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7. Positive accounting theory (PAT)
PAT predictions:
Organisations will seek to align interests of managers (agents) with interests of owners (principals).
This alignment relies on outputs of accounting.
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8. Positive accounting theory (PAT)
Efficiency perspective:
Mechanisms are made to minimise future agency costs (ex ante perspective).
Accounting methods adopted by firms best reflect the underlying financial performance of the entity.
Regulation is argued to impose unwarranted costs on reporting entities.
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9. Positive accounting theory (PAT)
Opportunistic perspective:
Considers actions that could be taken once various contractual arrangements have been put in place.
Assumes managers will opportunistically select accounting methods to increase their own personal wealth.
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10. Positive accounting theory (PAT)
Owner/manager contracting:
Managers assumed to act in own self-interest at the expense of owners:
‘Rational economic person’ assumption.
Managers have access to information not available to principals:
Information asymmetry.
Methods of reducing agency costs of equity:
Price protection
Monitoring by owners
Bonding by managers
Managing remuneration.
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11. Positive accounting theory (PAT)
Managers can be remunerated by:
fixed wages
performance based bonuses
combinations
each motivates different behaviour.
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12. Positive accounting theory (PAT)
Bonus schemes:
Remuneration is based on the output of the accounting system:
profits of the firm
sales of the firm
return on assets
may also be rewarded based on market price of shares.
Any change in accounting methods used will affect the calculations for these and therefore the bonuses paid.
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13. Positive accounting theory (PAT)
Bonus schemes (continued):
Rewarding managers on the basis of accounting profits can induce them 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.
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14. Positive accounting theory (PAT)
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 share options 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.
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15. Positive accounting theory (PAT)
Debt contracting:
An organisation in debt, may take steps to put off the repayment of debt by activities such as:
excessive dividends
claim dilution
asset substitution
investment in risky projects
these are referred to as the agency cost of debt.
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16. Positive accounting theory (PAT)
Debt contracting:
Ways to minimise the agency costs of debt:
Price protection
Higher interest charges
Contracting
Interest coverage clauses
Debt to asset clauses
Monitoring
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17. Positive accounting theory (PAT)
Political costs:
External parties to the firm might be able to affect the firm by seeking:
increased taxes
increased wage claims
product boycotts
decreased subsidies.
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18. Positive accounting theory (PAT)
Political costs:
Organisations are affected by governments, trade unions, environmental lobby groups or particular consumer groups
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
Management might:
Adopt income-reducing accounting techniques
Make voluntary social disclosures.
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19. Positive accounting theory (PAT)
Accounting policies:
Provide a basis for comparison between organisations
A summary of accounting policies must be presented in the notes to the financial report (NZ IAS 1 para 117)
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 (NZ IAS 8 para 29).
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20. Positive accounting theory (PAT)
However:
it is possible to be creative and still follow accounting standards
‘creative accounting’ refers to selecting accounting methods that provide the result desired by the preparers.
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21. 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.
Issues being addressed have not shown any significant development.
Scientifically flawed.
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22. Normative accounting theories
Seek to provide guidance in selecting accounting procedures that are most appropriate.
Prescribe what should be done.
Example – conceptual frameworks
Seek to identify the objective of GPFR
Seek to provide recognition and measurement rules within a ‘coherent’ and ‘consistent’ framework
Identify the qualitative characteristics financial information should possess
Make recommendations that depart from current practice.
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23. Some normative accounting theories
Current-cost accounting:
Provides 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).
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24. Some normative accounting theories
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.
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25. Some normative accounting theories
Deprival-value accounting:
Represents the amount of loss potentially incurred if an entity were deprived of the use of an asset.
This method considers:
the net selling price
the present value of future cash flows
an asset’s current replacement cost.
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26. Systems-oriented theories
Focus on the role of information and disclosure in 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.
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27. Systems-oriented theories
Stakeholder theory:
Ethical branch:
Stakeholders are groups or individual who can affect or are affected by the achievement of the organisation:
Includes shareholders, employees, customers, lenders, suppliers, local charities, interest groups, government.
All stakeholders have a right to be provided with information about how the organisation is affecting them.
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28. Systems-oriented theories
Managerial branch:
Seeks to explain and predict how an organisation reacts to stakeholder demands
Relative power or importance of stakeholders is considered
Relative power and importance can change
Firms will take action to ‘manage’ relationships
Financial and social information is used to control conflicting demands of various stakeholder groups.
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29. Systems-oriented theories
Legitimacy theory:
Organisations ensure they operate within the bounds and norms of society:
Based on a ‘social contract’ between society and the organisation.
Organisations must appear to consider rights of the public at large:
Society might otherwise:
‘Revoke’ its ‘contract’ to operate
Change demand for the organisation’s products
Demand taxes, fines or prohibit activity.
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30. Systems-oriented theories
Organisations ensure their activities are perceived to be legitimate:
They have no inherent right to resources
Right to operate depends on legitimacy from the society’s perspective.
To gain or maintain legitimacy, organisations might rely on disclosure:
One of the functions of accounting is to legitimate the existence of the organisation.
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31. Systems-oriented theories
Institutional theory:
Organisations tend toward homogeneous behaviour:
Structures and practices tend to become similar to conform to what is considered ‘normal’.
Links homogeneous accounting and corporate reporting practices to community values and the need to maintain organisational legitimacy.
Provides understanding of how organisations interpret/respond to changing social/institutional pressures/expectations.
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32. Systems-oriented theories
Institutional theory:
Two main dimensions:
Isomorphism:
“constraining process that forces one unit in a population to resemble other units that face the same set of environmental conditions”
Three different isomorphic processes: coercive, mimetic, normative.
Decoupling:
Actual organisational processes and practices differ widely from those formerly sanctioned and publicly pronounced
Organisational image constructed through corporate reports might be one of responsibility when actual managerial imperative is maximisation of profitability and shareholder value.
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33. Theories of regulation
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.
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34. Theories of regulation
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.
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35. Theories of regulation
Economic interest group theory:
Assumes groups form to protect particular economic interests.
Groups are in conflict with others and will lobby government to put in place legislation that will benefit them at the expense of others.
Regulators (and all other individuals) deemed to be motivated by self-interest.
The regulator is not a neutral arbiter but is seen as an interest group.
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36. Theories of regulation
Economic interest group theory (continued):
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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37. Critical theory
A measure for understanding ‘reality’, which understanding can be translated into progress and the development of societies that will enable a ‘truer, freer and more just life for all’.
Recognises the primacy of social relationships over technical approaches.
Allows an alternative approach to positivistic models.
Provides new and innovate approaches for research into accounting.
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38. Summary No single accounting theory is universally accepted.
Positive theories predict behaviour, normative prescribe what behaviour should be.
Systems orientated theories consider organisations within a larger social environment.
Regulation theories explain behaviour around regulation, the regulator and the regulated.
Critical theories provide a measure for reality, recognising social relationships.
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