1. THEORIES OF FINANCIAL ACCOUNTING
Slides adapted from Chapter 3
Deegan 8th Edition power point slides
Deakin University CRICOS Provider Code: 00113B

2. Objectives of this lecture
Appreciate why students of financial accounting should know about various theories of accounting.
Appreciate that there is no single unified theory of accounting, and be aware of some of the limitations of the various theories of accounting.
Be able to describe various normative and positive theories of financial accounting.
Understand the various pressures and motivations that might have an effect on the methods of accounting selected by an organisation.
Understand that the choice of alternative accounting policies can be explained from either an ‘efficiency perspective’ or from an ‘opportunistic perspective’.

3. Objectives of this lecture (cont.)
Understand what is meant by ‘creative accounting’ and why it might occur.
Understand that there are theories that explain why regulation—such as accounting regulation—is introduced.

4. Overview of lecture
This lecture provides an overview of the following four broad areas of accounting theory and research:
Normative theories of accounting
Positive theories of accounting
Systems-oriented theories explaining accounting practice
Accounting theory related to regulation

5. What is theory?
Theory has different connotations, depending on the context in which the noun is used:
Something not yet established as fact
Something that doesn’t conform with reality
The basic principles underlying an activity
Theories perform three functions:
1.Explain
2.Predict
3.Recommend

6. Theory definition
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)

7. Approaches to accounting theory
Theories can be divided into prescriptive and descriptive
Normative theories come from a desire to prescribe a norm, a standard or a model which is the ideal – a prescriptive theory that involves value judgements.
Positive theories explain or predict the real world phenomena and these theories are tested empirically.

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Empirical accounting research
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9. Positive Accounting Theory (PAT)
A positive theory of accounting (PAT) is a theory that seeks to explain and predict particular accounting practices.
Accordingly, PAT distinguishes research that seeks to explain and predict from research that aims to provide prescription.
PAT is one of several positive theories of accounting, the others are Legitimacy, Institutional and Stakeholder Theories.

10. 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.

11. Positive Accounting Theory (PAT) (cont.)
What is PAT’s focus?
PAT focuses on the relationships between the various individuals involved in providing resources to an organisation:
Between owners (as suppliers of equity) and managers (as suppliers of managerial labour)
Between managers and the firm’s debt providers
Many relationships involve the delegation of decision making from one party (the principal) to another party (the agent), referred to as an agency relationship.

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The agency problem - basics
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13. Positive Accounting Theory (PAT) (cont.)
Agency relationships and costs
The delegation of decision-making authority by the principal (the owner) to the agent (the manager) can lead to a loss of efficiency and, consequently, increased costs.
Any loss of profits brought about because the manager underperforms is a cost of decision-making delegation within this agency relationship, that is, an agency cost of equity.
Accordingly, PAT investigates how particular contractual arrangements can be put in place to minimise agency costs.

14. Positive Accounting Theory (PAT) (cont.)
Agency relationships and costs (cont.)
PAT predicts organisations seek to put into place mechanisms that align the interests of the managers of the firm (the agent) with the interests of the owners of the firms (the principals).
Where such accounting-based alignment mechanisms are in place, financial statements will need to be produced (i.e., bonding costs).
PAT also predicts that where financial statements are required to be produced, there is demand for those statements to be audited or monitored (i.e., monitoring costs).

15. Positive Accounting Theory (PAT) (cont.)
Agency relationships and costs (cont.)
PAT assumes that not all the opportunistic actions of agents can be controlled by contractual arrangements or otherwise, there will always be some residual costs associated with appointing an agent (i.e., residual loss).

16. Positive Accounting Theory (PAT) (cont.)
Efficiency and opportunistic perspectives of PAT
Efficiency perspective
PAT explains how various contracting mechanisms can be put in place to minimise the agency costs of the firms.
The efficiency or ex ante (‘before the fact’) perspective considers what mechanisms are introduced up front by the firm to minimise 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.
The ex ante or efficiency perspective also argues that accounting practices adopted by firms underlie the financial performance of the entity.

17. Positive Accounting Theory (PAT) (cont.)
Efficiency perspective of PAT (cont.)
PAT argues that regulation of financial accounting imposes unwarranted costs on reporting entities
For example, an imposed new accounting method via an
accounting standard or regulation is likely to lead to an
increase in the firm’s costs
PAT argues that management is best able to select which accounting methods are appropriate in given circumstances, and government should not intervene in the process.

18. Positive Accounting Theory (PAT) (cont.)
Opportunistic perspective
In contrast to the efficiency perspective, PAT seeks to explain and predict certain opportunistic behaviours that will subsequently occur (i.e., ex post or ‘after the fact’) 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

19. Principal-agent problem & alignment

20. Positive Accounting Theory (PAT) (cont.)
Owner/Manager contracting
All action taken by an individual is driven by self-interest, and that the major interest of all individuals is to maximise their own wealth (rational economic assumption).
Accordingly, owners (principals) would expect managers (agents) to undertake activities that might not be in the best interests of the owners.
Managers will have access to information that is not available to principals (information asymmetry), thus increasing the potential for managers to take actions that are beneficial to themselves at the expense of the owners (agency costs).

21. Positive Accounting Theory (PAT) (cont.)
Owner/Manager contracting (cont.)
As principals assume that agents will be driven by self-interest, principals will price this into the amounts they are prepared to pay managers.
This lower salary compensates the principals for, or protects them from, the expected opportunistic behaviour of the agents, and managers thus bear some of the agency costs of the opportunistic behaviours.
Managers may be rewarded:
on a fixed basis
on the basis of the results achieved
on a basis that combines the two

22. 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

23. 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 organization.

24. Positive Accounting Theory (PAT) (cont.)
Incentives to manipulate accounting numbers
Rewarding managers on the basis of accounting profits can induce them to manipulate the related accounting numbers to improve their apparent performance and related rewards
Research (e.g., Healy, 1985; Holthausen et al., 1995) has found that when schemes exist that reward managers after a pre- specified level of earnings had been reached, managers will adopt accounting methods consistent with maximising that bonus
Similarly, rewarding managers on the basis of accounting profits might discourage them from adopting investment strategies that maximise the present value of the firm’s resources (i.e., short-term versus long-term focus)

25. Positive Accounting Theory (PAT) (cont.)
Market-based bonus schemes
Alternatively, managers approaching retirement could be rewarded in terms of market-based schemes such as:
– Basing a cash bonus on any increases in share prices
– Providing managers with shares or option to shares in the firm
If the value of the firm’s shares increases, both managers and owners will benefit and, importantly, managers will be given an incentive to increase the value of the firms.

26. Positive Accounting Theory (PAT) (cont.)
Limitations market-based bonus schemes
Share price is not only affected by factors controlled by managers but also by outside, market-wide factors
Only senior managers would likely to have a significant effect on the cash flows of the firm and, hence, the value of the firms’ securities
Offering shares to lower management might be demotivating, as their own individual actions would have little likelihood , relative to senior management, of affecting share prices

27. Positive Accounting Theory (PAT) (cont.)
Debt contracting When a party lends funds to another organisation, the recipient of the funds might undertake activities that reduce or even eliminate the probability of the funds being repaid, leading to what is known as agency cost of debt

28. Positive Accounting Theory (PAT) (cont.)
Examples of agency costs of debt are:
Recipients of funds might pay excessive dividends, leaving few assets in the organisation to service the debt.
Recipients of funds might take on new debt, leaving original debt holders to compete with new debt holders for repayment, resulting in a ‘claim dilution’ problem (Smith & Warner, 1979).
Recipients of funds might also invest in high risk projects which might fail leaving the debt holder with no repayment.

29. 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

30. Positive Accounting Theory (PAT) (cont.)
Political costs -Political costs refer to the costs that particular groups external to the firm may be able to impose on the firm, such as costs associated with increased taxes, increased wage claims or product boycotts. -Organisations are affected by government, trade unions, environmental lobby groups, consumer groups, and other interest groups. -Demands placed on firms by interest groups might be affected by the accounting results of the firm, such as profits, which might lead to the imposition of additional costs on the firm through increased taxes, reduction in the prices of products the firm makes, or wage increases.

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

32. 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 (and assets) and thereby ‘loosen’ debt covenants
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

33. Criticisms of PAT A number of PAT’s assumptions have been criticised:
PAT restricts itself to providing descriptive questions, thereby failing to provide prescription and thus not providing a means of improving accounting practice;
While PAT asserts that it is value-free, critics highlight that it is indeed value-laden. For example, the very act of selecting a theory for research purposes is based on value judgement;

34. Criticisms of PAT (cont.)
The assumption that all human action is driven by self-interest and a desire to maximise wealth promotes a ‘morally bankrupt view of the world’ and is not a kind assumption about human nature;
As the three hypotheses generated by PAT are frequently not supported by research but, rather, are falsified, PAT should be rejected as it is scientifically flawed.

35. 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

36. 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

37. 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

38. Systems-oriented theories
An entity is assumed to be influenced by the society in which it operates and in turn to have an influence on society
Systems-oriented theories explain the role of information and disclosure in managing the relationship between an organisation and the communities within which it interacts.

39. The organisation viewed as part of a wider social system

40. Systems-oriented theories (cont.)
Accounting disclosure policies are considered to constitute a strategy to influence or manage the relationships between the organisation and other parties with which it interacts, and these strategies are explained in the following 3 approaches:
Stakeholder theory
Legitimacy theory
Institutional theory

41. Systems-oriented theories (cont.)
Stakeholder theory
This theory considers the importance for an organisation’s survival of satisfying the demands of its various stakeholders
Stakeholders can be “any group or individual who can affect or is affected by the achievement of the firm’s objectives” (freeman, 1984), e.g., Shareholders, employees, customers, etc.
Stakeholder theory has both an ethical (‘normative’) and a managerial (‘positive’) aspect

42. Systems-oriented theories (cont.)
Stakeholder Theory (cont.)
Ethical (normative) branch
believes that all stakeholders have intrinsic rights (.e.g., safe-working environment) and these rights are inviolable.
all stakeholders have a right to be provided with information about how the organisation is affecting them, even if they choose not to use the information.
As the ethical view espouses normative views about how the organisation should act towards their stakeholders, this perspective cannot be validated by empirical observation.

43. Systems-oriented theories (cont.)
Stakeholder Theory (cont.)
Managerial (positive) branch
to explain and predict how organisations will react to demands of various stakeholder groups
Relative power and importance of stakeholders is considered —associated with ongoing operations and control of resources
Relative power and importance can change across time
The firm will take actions to ‘manage’ its relationships with these more powerful and important stakeholders

44. 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 organization
Where this social contract is perceived as being breached then the organisation will take corrective action, and this action might include disclosure

45. 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 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’

46. 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.
Under this theory organisations adopt particular practices—including disclosure practices—because doing so provides legitimacy.
Particular practices might be adopted despite the fact they are not necessarily the most efficient practices.
Institutional Theory has two dimensions, isomorphism and decoupling

47. 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

48. 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

49. 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).

50. 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

51. 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

52. 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
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)

53. 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

54. 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

55. 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 in accounting issues