GODFREY

HODGSON
HOLMES
TARCA

Dr. Zaroni, CISCP, CFMP, CMILT

Lecture #11 17 April 2021
Positive theory of accounting policy and disclosure Universitas Multimedia
Nusantara
Topics discussed
• Positive theory
• Contracting theory
• Political process theory
• Signalling theory
• Accounting policy and the management of
accruals
Contracting theory – why the firm can be
described as a “nexus of contracts”

Agency theory – how accounting is used in

contractual specifications to reduce the agency
costs of equity and debt
Learning
Price protection and shareholder/manager
agency problems – constraining opportunistic
objectives
accounting reporting by managers

Shareholder – debtholder agency problems –

how managers’ ex post accounting decisions can
transfer wealth from lenders to equity holders

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Signaling theory – how accounting can be used to
signal information about the firm

Political processes – how accounting can be used to

reduce the political costs faced by the firm

Conservatism, accounting standards, and agency

costs – accounting standards as an agency constraint Learning
Additional empirical tests of the theory
objectives
Evaluating the theory - key criticisms of accounting
theories of accounting choice

issues for auditors

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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

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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
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)

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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

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Agency theory

• The agency problem in turn gives rise to agency costs spent to overcome it
• monitoring costs
• bonding costs
• residual loss

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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…

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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

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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

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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

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

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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

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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

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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

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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

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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

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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

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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)

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

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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

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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

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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

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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

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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

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Ex post opportunism
versus ex ante efficient
contracting

Ex post opportunism
• occurs when, once a contact is in place,
agents take actions that transfer wealth from
principals to themselves

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 Ex post opportunism
versus ex ante
efficient contracting

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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
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

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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

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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

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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

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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

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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

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6

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
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

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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

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Reference
Godfrey, Accounting Theory, 7
Edition, Wiley, 2010