ACF3100 Advanced Financial Accounting

Lecture Two Accounting Theories and Research

Learning Objectives
Evaluate how theories can enhance our understanding of accounting practice
Contrast positive with normative theories in accounting
Explain positive accounting theory and examine how it explains disclosures and accounting practice
(eg: expense vs. capitalisation, accounting estimates etc.)
Understand agency costs: the agency problems between managers and shareholders; the agency
problems between managers and debtholders; and how accounting number can be used to mitigate
these agency problems
Explain institutional theory and examine how it explains accounting disclosure practice
Explain stakeholder theory and examine how it prescribes and explains accounting practice

Where Does This Fit into Unit Learning Goals?

Examine contemporary financial accounting issues
Apply a range of theories of accounting to explain accounting practices and appreciate the judgments,
estimations and assumptions influencing accounting numbers
Critically assess and appreciate changing influences in standard setting and regulatory requirements
Apply judgement, communication and problem solving skills to deal with advanced financial accounting
issues

Accounting Theory
Accounting is viewed as a practical discipline
o Rule focused
o With little use for theory
However, theory is necessary to
o Understand the world we live in
o Provide a basis for decision making
All accounting is premised on theories, eg:
o The Conceptual Framework
o Definition of accounting elements and recognition criteria
o Measurement bases

Theory Defined
Theory can mean a lot of different things
Dictionary definition:
o A belief or principle that guides actions or behaviour
o An idea or set of ideas that is intended to explain something
The set of principles on which a subject is based or of ideas that are suggested to
explain a fact or event

Accounting Theory Defined

A description, explanation or a prediction (of accounting practice) based on observations and/or logical
reasoning
Logical reasoning in the form of a set of broad principles
1. Provide a general framework of reference by which accounting practice can be evaluated and
2. Guide the development of new practice and procedures

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What Value Does Accounting Theory Offer?

Accounting theories provide principles for decision making
Accounting theories help us understand
o Decisions of financial report preparers
o Actions of financial report users
o Influences of organisational environment
o Potentially better accounting and financial reporting practice

Types of Theories
Normative Theories
Recommend what should happen very subjective and only a recommendation, depends on the
person applying the theory
Prescribe action to achieve specific objectives
Eg: The Conceptual Framework, prescribes the objective of financial reports and the qualitative of
information

Positive Theories
Describes, explains or predicts activities allows you to test and prove theories/situations
Help us understand what happens in the world
Based around hypotheses, a lot of testing
Also called empirical theories how is the theory applied in real world practice
Eg: agency theory claims that self-interests drive managers to engage in opportunistic financial
reporting

Where Positive Theories Come From

Quiz

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Examples
Positive Accounting Theory
Used to explain and predict accounting practice
o Often used to explain choice of accounting policies or the decision to provide information
It examines a range of relationships between the entity and
o Suppliers of equity capital (owners) not focusing on this unit
o Managerial labour (management) main focus
o Debt capital (lenders or debt holders) main focus
Based on the rational economic person assumption: every shareholder has self-interest and tries to
maximise their own wealth
Incorporates contracting and agency theories

Contracting Theory
Suggests that the organisation is characterised as a legal nexus of contracts
With contracting parties having right and responsibilities under these contracts
Positive accounting theory focuses on
o Managerial contracts, and
o Debt contracts
These are agency contracts used to manage relationships where there is a separation between
management and capital providers

Agency Theory
Used to understand relationships whereby a principal employs the services of, and delegates the
decision-making authority to, an agent
Creates a moral hazard
o The risk that managers might undertake actions that are detrimental to owners or other
principals
If the interests of principal and agent are not aligned there are incentives for agent to act in a way not
in the bets interest of the principal
o Excessive perquisite (unnecessary consumptions of firm resources)
o Shirking (reducing workloads)
o Empire building (expanding firm size beyond shareholders interests)
o Incorrect investment decisions (avoiding risky yet promising projects)
Leads to three agency costs: monitoring costs, bonding costs and residual loss

Agency Costs

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RL

MC
BC

MC

Owner-Manager Agency Relationships

Agency theory identifies a number of problems that can exist between managers and owners
Contracts and accounting information can be used to bond the interests of owners and managers
Addresses three specific problems
o Horizon problem
o Risk aversion
o Dividend retention

Manager-Lender Agency Relationships

When a lender agrees to provide funds to an entity there is the risk that the lending party may not
repay those funds
o Excessive dividend payments
o Underinvestment
o Asset substitution
o Claim dilution
To avoid higher interest costs, managers have incentives to show they are acting in a way that is not
detrimental to lenders
Manager refers to whole company in this relationship assuming that manager and shareholder have
the same interests now as they are representing the company

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Role of Accounting Information in Reducing Agency Problems

Accounting information forms one of the major components of both manager remuneration and
lending contracts
For managers, accounting information plays two roles in the contracting process
o To write the terms of managerial contracts
o To determine performance against the terms of the contracts and consequently the amount
of bonus and other pay components managers will receive
Lenders look to regular financial updates to ensure companies are maintaining the terms of their
covenants

Information Asymmetry
Results from managers having more information about the current and future prospects of the entity
than outsiders
Managers can choose when and how to disseminate this information
Under positive accounting theory there are incentives to disclose most news, good or bad, to the
market

Institutional Theory
Comes from management literature
It considers how rules, norms and routines become established as authoritative guidelines, and
considers how these elements are created, adopted and adapted over time
Practices within organisations can be predicted from perceptions of legitimate behaviour derived from
cultural values, industry tradition, entity values etc.

Legitimacy Theory
Based on the idea of a social contract
o Relates to the explicit and implicit expectations society has about how businesses should act
to ensure they survive into the future
o Organisations need to show they are operating in accordance with the expectations in the
social contract
Organisational legitimacy
o The values and norms evident in the social contract have changed over time

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o In the past legitimacy was considered only in terms of economic performance

o Now businesses are expected to consider a range of issues, including the environmental and
social consequences of their activities

Accounting Disclosures and Legitimation

Lindblom (1994) identifies four ways an organisation can obtain or maintain legitimacy:
o Seek to educate and inform society about actual changes in the organisations performance
and activities
o Seek to change the perceptions of society, but not actually change behaviour
o Seek to manipulate perception by deflecting attention from the issue of concern to other
related issues
o Seek to change expectations of its performance
Disclosure of information about an organisations effect on, or relationship with society can be used
o An entity might provide information to offset negative news which may be publicly available
o An organisation may draw attention to strengths
Public reporting through the annual report or the entity website can be a powerful tool in showing an
organisation is meeting the expectations of society

Stakeholder Theory
Considers the relationship that exists between the organisation and its various stakeholders
Stakeholders are any group or individual who can affect or is affected by the achievements of an
organisations objectives
There are two versions of stakeholder theory
o A normative theory, known as the ethical branch
o An empirical theory of management, which is a positive theory

Normative Branch of Stakeholder Theory

Argues that organisations should treat all their stakeholders fairly
An organisation should be managed for the benefit of all its stakeholders
Stakeholders are identified, and should be considered in organisational decisions because of their
interest in the activities of the organisation

Managerial Branch of Stakeholder Theory

Seeks to explain how stakeholders influence organisational actions
The extent to which an organisation will consider its stakeholders is related to the power or influence
of those stakeholders
o A stakeholders power is related to the degree of control they have over resources required
by the organisation

Role of Accounting Information in Stakeholder Theory

One important way of meeting stakeholders needs and expectations is providing information about
organisational activities and performance
Stakeholder theory has been used to examine disclosure of voluntary information to stakeholders,
most commonly relating to social and environmental performance

Using Theories to Understand Accounting Decisions

Accountants use judgment to make a range of accounting decisions on a daily basis
Examples include:
o Whether to expense or capitalise costs

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o What accounting estimates to use

o What, where and how to disclose information
Theories offer some assistance in explaining managers and accountants decisions

Expensing and Capitalising Costs

Agency theory would hold that
o Managers on compensation contracts which have bonuses tied to a current measure of entity
performance
o Entities with lending agreements with a leverage covenant, would prefer to capitalise on costs

Accounting Estimates
Agency contracts can explain managerial decisions in this regard
o Managers and accountants, acting in self interest, are likely to ensure their own bonuses are
maximised and the entity is not at risk of breaching debt contracts
Legitimacy and stakeholder theory suggests there are times entities, for political reasons, will actively
reduce their reported profits

Disclosure Policy
Disclosure policy relates to additional disclosure within the annual report or media releases
Stakeholder theory would explain these disclosures in terms of providing relevant information to
maintain relationships with powerful stakeholders
Legitimacy theory sees voluntary disclosure as a way of maintaining or regaining legitimacy by
demonstrating how the entity is meeting societal expectations