Download Chapter 2

Theories of financial
accounting
Chapter 2
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin
Slides prepared by Grant Samkin and Annika Schneider
2-1
Learning 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
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin
Slides prepared by Grant Samkin and Annika Schneider
2-2
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 practice
(normative theories)
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PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin
Slides prepared by Grant Samkin and Annika Schneider
2-3
Positive accounting theory (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
(Continues)
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PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin
Slides prepared by Grant Samkin and Annika Schneider
2-4
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
(Continues)
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PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin
Slides prepared by Grant Samkin and Annika Schneider
2-5
Positive accounting theory (PAT)
(cont.)
Agency costs
• Monitoring costs
• Bonding expenditures
• Residual loss
(Continues)
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PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin
Slides prepared by Grant Samkin and Annika Schneider
2-6
Positive accounting theory (PAT)
(cont.)
Assumptions of PAT
• All individual action is driven by self-interest
• 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
(Continues)
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PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin
Slides prepared by Grant Samkin and Annika Schneider
2-7
Positive accounting theory (PAT)
(cont.)
PAT predictions
• Organisations will seek to put in place mechanisms
to align the interests of the managers of the firm
(agents) with the interests of the owners of the
firm (principals)
• Some of these mechanisms rely on the output
of the accounting system
(Continues)
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin
Slides prepared by Grant Samkin and Annika Schneider
2-8
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
Referred to as ex ante perspective
Accounting methods adopted by firms best reflect
the underlying financial performance of the entity
Regulation is therefore argued to impose unwarranted
costs on reporting entities
(Continues)
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PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin
Slides prepared by Grant Samkin and Annika Schneider
2-9
Positive accounting theory (PAT)
(cont.)
• Opportunistic perspective
–
–
Considers opportunistic 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
(Continues)
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin
Slides prepared by Grant Samkin and Annika Schneider
2-10
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
(Continues)
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin
Slides prepared by Grant Samkin and Annika Schneider
2-11
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
(Continues)
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PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin
Slides prepared by Grant Samkin and Annika Schneider
2-12
Positive accounting theory (PAT)
(cont.)
Bonus schemes
• Remuneration based on the output of
the accounting system
• Based on:
–
–
–
Profits of the firm
Sales of the firm
Return on assets
• May also be rewarded based on market
price of shares
(Continues)
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin
Slides prepared by Grant Samkin and Annika Schneider
2-13
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)
• Contracts may rely on ‘floating’, generally-
accepted accounting principles
(Continues)
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PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin
Slides prepared by Grant Samkin and Annika Schneider
2-14
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 thus the related rewards
• Accounting profits might not always provide an
unbiased measure of a firm’s performance
(Continues)
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin
Slides prepared by Grant Samkin and Annika Schneider
2-15
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
(Continues)
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin
Slides prepared by Grant Samkin and Annika Schneider
2-16
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
(Continues)
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PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin
Slides prepared by Grant Samkin and Annika Schneider
2-17
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
(Continues)
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin
Slides prepared by Grant Samkin and Annika Schneider
2-18
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
(Continues)
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin
Slides prepared by Grant Samkin and Annika Schneider
2-19
Positive accounting theory
(PAT) (cont.)
Debt contracting
• Agency costs of debt:
–
–
–
–
Excess dividends
Claim dilution
Asset substitution
Investment in risky projects
• It is assumed that the managers’ interests are
aligned with the shareholders’ interests
(Continues)
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PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin
Slides prepared by Grant Samkin and Annika Schneider
2-20
Positive accounting theory (PAT)
(cont.)
Ways to minimise the agency costs of debt
• Price protection
–
Higher interest charges
• Contracting
–
–
Interest coverage clauses
Debt to asset clauses

leverage clauses frequently used in Australian
bank loan contracts
• Monitoring
(Continues)
Copyright  2006 McGraw-Hill Australia Pty Ltd
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Slides prepared by Grant Samkin and Annika Schneider
2-21
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
(Continues)
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2-22
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
(Continues)
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2-23
Positive accounting theory
(PAT) (cont.)
Ways to reduce political costs
• Management might:
–
–
Adopt income-reducing accounting techniques
Make voluntary social disclosures
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2-24
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
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2-25
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 (NZ IAS 1 para 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 (NZ IAS 8 para 29)
(Continues)
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2-26
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
• It is possible to be creative and still follow
accounting standards
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PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin
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2-27
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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2-28
Normative accounting theories
• Seek to provide guidance in selecting accounting
procedures that are most appropriate
• Prescribe what should be done
(Continues)
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2-29
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
(Continues)
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin
Slides prepared by Grant Samkin and Annika Schneider
2-30
Normative accounting theories
(cont.)
Other normative theories
• Three main classifications:
1.
2.
3.
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
(Continues)
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2-31
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)
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PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin
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2-32
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
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin
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2-33
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
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2-34
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
(Continues)
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2-35
Systems-oriented theories (cont.)
Stakeholder theory
• Two branches:
1.
2.
Ethical (normative) branch
Managerial (positive) branch
• Ethical 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
All stakeholders have a right to be provided with
information
(Continues)
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Slides prepared by Grant Samkin and Annika Schneider
2-36
Systems-oriented theories (cont.)
Stakeholder theory (cont.)
• Managerial 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
(Continues)
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2-37
Systems-oriented theories (cont.)
Stakeholder theory (cont.)
• Managerial branch (cont.)
–
Financial and social information is used to control
conflicting demands of various stakeholder groups
• 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
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2-38
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
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2-39
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
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2-40
Theories explaining why
regulation is introduced
• Public interest theory
• Capture theory
• Economic interest group theory
(Continues)
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2-41
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
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2-42
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
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PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin
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2-43
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
(Continues)
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a New Zealand Financial Accounting 3e by Grant Samkin
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2-44
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
Copyright  2006 McGraw-Hill Australia Pty Ltd
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2-45
Summary
• The chapter describes various theories that relate
to financial accounting
• No single accounting theory is universally accepted
• A theory is defined as a ‘coherent group of
propositions used as an explanation for a
class of phenomena’
(Continues)
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2-46
Summary (cont.)
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 be a
desire to maximise wealth (a perspective often criticised by
other researchers)
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2-47
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
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2-48
Summary (cont.)
Systems-based theories
• Include Stakeholder theory and Legitimacy 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 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
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2-49
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
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2-50