Chapter 3

Chapter 3
Theories of financial
accounting
Copyright 2010 McGraw-Hill Australia Pty Ltd

PPTs to accompany Deegan, Australian Financial Accounting 6e
3-1
Objectives of this lecture

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
.

3-2
Why do we bother discussing theories when we

are studying financial accounting?
We believe that not only is it useful to discuss the
requirements of the various accounting standardsas we
will do in depth in the following weeksbut that it is
important to provide frameworksas we do in this lecture
within which to consider the implications of
organisations making particular accounting disclosures,
whether voluntarily or as a result of a particular mandate
We also think it is useful to consider the various
pressures, many of which are political in nature, that
influence the accounting standard-setting environment

3-3
Why do we bother discussing theories when we

are studying financial accounting? (cont.)
Because the impact of financial accounting resonates
throughout society it is important to understand the
possible implications of an organisation making
particular disclosures
Theories also provide us with the basis for understanding
the various pressures that drive organisations to make
particular disclosures, even in the absence of disclosure
requirements pertaining to particular transactions and
events
By covering the material in this lecture, students will gain
a greater understanding of the implications of various
accounting standards and other disclosure requirements
(the development of thinking accountants!)

3-4
Theory definitionwhat is a theory?

A coherent group of propositions or principles
forming a general framework of reference for a field
of inquiry
Accounting theoriesand there are manyoften
explain and predict accounting practice (referred to
as positive theories) or prescribe particular practice
(referred to as normative theories)

3-5
Positive Accounting Theory (PAT)

The first theory we shall describe is Positive
Accounting Theory (popularised by Watts and
Zimmerman)
Positive Accounting Theory is an example of a
positive theory of accounting. As we will see later,
there are other positive theories of accounting (as
well as normative theories of accounting)
PAT explains and predicts accounting practice

3-6
Positive Accounting Theory (PAT) (cont.)

PAT 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

3-7

PAT accounting theory was developed, in part, from
another theory known as agency theory. Agency theory
discusses agency relationships, problems and costs.
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

3-8

Agency costs
Monitoring costs
Bonding expenditures
Residual loss

3-9

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

3-10
Positive Accounting Theory (PAT)

(cont.)
PAT predictions
To try to improve efficiency, organisations will seek
to put in place mechanisms to align the interests of
managers of the firm (the agents) with the interests
of the owners (principals)
Some of these mechanisms rely on the output of the
accounting system
For example, owners might agree to pay a manager a
bonus based on a specified percentage of profits

3-11

Efficiency and opportunistic perspectives of PAT
Efficiency perspective
Mechanisms are put in place up front with the
objective of minimising 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
Voluntary audits might be undertaken to reduce
the perceived risks of investors
Referred to as ex ante perspective

3-12

Efficiency perspective of PAT (cont.)
Accounting methods adopted by firms best reflect the
underlying financial performance of the entitymight
select the most efficient way to portray the performance
of the entity
Regulation is therefore argued by PAT advocates to
impose unwarranted costs on reporting entitiesit
causes the firm to provide an inefficient perspective of
the performance and position of the organisation as it
requires movement to a one-size-fits-all approach to
reporting

3-13

Efficiency and opportunistic perspectives of PAT (cont.)
Opportunistic perspective
Considers opportunistic actions that could be taken 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 willto the extent they can get
away with itbe 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

3-14

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

3-15

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

3-16

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
.

3-17

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 organisation
Contracts may rely on floating, generally accepted
accounting principles

3-18

Incentives to manipulate accounting numbers
Rewarding managers on the basis of accounting
profits can induce them subsequently 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 firms performanceso also
common to find the use of share-based reward
structures, which in certain circumstances might be
deemed to be more efficient

3-19

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

3-20

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

3-21

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
Some research indicates that the greater the
separation between managers and owners, and the
greater the reliance on external debt (meaning
greater potential agency costs), the greater the
likelihood that voluntary financial statements would
be undertaken
.

3-22

Other mechanisms that align the interests of
managers and owners
Threat of takeovers to underperforming firms
A well-informed labour market

3-23

Debt contracting
Agency costs of debt:
excess dividends
claim dilution
asset substitution
investment in risky projects
When discussing the agency costs of debt it is

assumed that the managers interests are aligned
with the shareholders interests

3-24

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

3-25

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

3-26

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
There will be a perception that highly profitable
organisations can afford to pay higher salaries,
higher taxes, reduce pricesso if firms reduce
profits such expectations might decrease
.

3-27

Ways to reduce political costs
Management might:
adopt income-reducing accounting techniques
make voluntary social disclosures

3-28
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
firms debt/equity ratio, the more likely managers will be to
use accounting methods that increase income
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
So, in considering the usefulness of PAT, how might auditors
utilise the above hypotheses/predictions when undertaking a
financial statement audit?

3-29
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

3-30
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 (AASB 101, par. 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 (AASB 108, par. 29)
PAT provides potential insights into why managers might
elect to select or change accounting policies

3-31
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
PAT provides one perspective on why creative
accounting might occur (of course, there could be
other perspectives)
It is possible to be creative and still follow
accounting standards
.

3-32
Criticisms of PAT
Does not provide prescription so does not provide a
means of improving accounting practice
Not value-free but rather is value-laden
Underlying assumption of wealth maximisation is
simplistic
Issues being addressed have not shown any
significant development
Scientifically flawed

3-33
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

3-34
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 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

3-35
Normative accounting theories ( cont.)

Other normative theories
Three main classifications
1. Current-cost accounting
2. Exit-price accounting
3. Deprival-value accounting
These theories addressed issues associated with

changing prices
Developed in 1950s and 1960s during a period of
high inflation

3-36

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)

3-37

Exit-price accounting
Continuously Contemporary Accounting
Uses exit or selling prices to value the entitys 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

3-38

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 assets current replacement cost

3-39
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
Institutional Theory

3-40
The organisation viewed as part of a wider

social system

3-41
Systems-oriented theories (cont.)

Stakeholder Theory
Two branches
1. Ethical (normative) branch
2. Managerial (positive) branch
1. Ethical (normative) branch

Stakeholders are any group or individual who can
affect or are affected by the achievement of the firms
objectives
Includes shareholders, employees, customers,
lenders, suppliers, local charities, interest groups,
government
All stakeholders have a right to be provided with
information

3-42

Stakeholder Theory (cont.)
1. Ethical (normative) branch (cont.)
Because it prescribes how stakeholders should be treated
(based on various ethical perspectives), it is a normative
approach and is based on various ethical perspectives
2. Managerial (positive) 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

3-43

Stakeholder Theory (cont.)
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
2. Managerial branch (cont.)
Financial and social information is used to control conflicting
demands of various stakeholder groups
Management will respond to the information demands of
stakeholders perceived as being powerful
From this perspective, if a stakeholder group does not have
power then their information demands might not be met

3-44

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

3-45

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 (and a number of studies
are referred to in the textbook) 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
.

3-46

Explains why organisations within particular fields
tend to take on similar characteristics and form
Much overlap with Legitimacy Theory and
Stakeholder Theory
Two main dimensions to the theoryisomorphism
and decoupling

3-47

Institutional Theory (cont.)
Isomorphism
coercive
mimetic
normative
Decoupling
Actual practices can be very different from formally
sanctioned and publicly pronounced processes and
practices

3-48
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

3-49
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

3-50

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)

3-51

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

3-52

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

3-53
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 markets 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)

3-54
Summary (cont.)
Normative theories of accounting
Prescribe how accounting should be practised
Argue typically that a central role of accounting theory is to
provide prescriptioninform 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

3-55
Summary (cont.)
Systems-based theories
Include Stakeholder Theory, Legitimacy Theory, and

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 organisationorganisational activities
and accounting disclosures are considered to be reactive
to community pressureshow a firm operates and what it
reports must be determined upon consideration of various
stakeholder expectations
3-56
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
theoryhowever, different theoretical perspectives can at
various times provide valuable insights in accounting issues

3-57

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Chapter 3

Copyright 2010 McGraw-Hill Australia Pty Ltd

Objectives of this lecture

Copyright 2010 McGraw-Hill Australia Pty Ltd

Why do we bother discussing theories when we

Copyright 2010 McGraw-Hill Australia Pty Ltd

Why do we bother discussing theories when we

Copyright 2010 McGraw-Hill Australia Pty Ltd

Theory definitionwhat is a theory?

Copyright 2010 McGraw-Hill Australia Pty Ltd

Positive Accounting Theory (PAT)

Copyright 2010 McGraw-Hill Australia Pty Ltd

Positive Accounting Theory (PAT) (cont.)

Copyright 2010 McGraw-Hill Australia Pty Ltd

Positive Accounting Theory (PAT) (cont.)

Copyright 2010 McGraw-Hill Australia Pty Ltd

Positive Accounting Theory (PAT) (cont.)

Copyright 2010 McGraw-Hill Australia Pty Ltd

Positive Accounting Theory (PAT) (cont.)

Copyright 2010 McGraw-Hill Australia Pty Ltd

Positive Accounting Theory (PAT)

Copyright 2010 McGraw-Hill Australia Pty Ltd

Positive Accounting Theory (PAT) (cont.)

Copyright 2010 McGraw-Hill Australia Pty Ltd

Positive Accounting Theory (PAT) (cont.)

Copyright 2010 McGraw-Hill Australia Pty Ltd

Positive Accounting Theory (PAT) (cont.)

Copyright 2010 McGraw-Hill Australia Pty Ltd

Positive Accounting Theory (PAT) (cont.)

Managers have access to information not available

Copyright 2010 McGraw-Hill Australia Pty Ltd

Positive Accounting Theory (PAT) (cont.)

Copyright 2010 McGraw-Hill Australia Pty Ltd

Positive Accounting Theory (PAT) (cont.)

May also be rewarded based on market price of

Copyright 2010 McGraw-Hill Australia Pty Ltd

Positive Accounting Theory (PAT) (cont.)

Copyright 2010 McGraw-Hill Australia Pty Ltd

Positive Accounting Theory (PAT) (cont.)

Copyright 2010 McGraw-Hill Australia Pty Ltd

Positive Accounting Theory (PAT) (cont.)

Copyright 2010 McGraw-Hill Australia Pty Ltd

Positive Accounting Theory (PAT) (cont.)

Copyright 2010 McGraw-Hill Australia Pty Ltd

Positive Accounting Theory (PAT) (cont.)

Copyright 2010 McGraw-Hill Australia Pty Ltd

Positive Accounting Theory (PAT) (cont.)

Copyright 2010 McGraw-Hill Australia Pty Ltd

Positive Accounting Theory (PAT) (cont.)

When discussing the agency costs of debt it is

Copyright 2010 McGraw-Hill Australia Pty Ltd

Positive Accounting Theory (PAT) (cont.)

Copyright 2010 McGraw-Hill Australia Pty Ltd

Positive Accounting Theory (PAT) (cont.)

Organisations are affected by governments, trade

Copyright 2010 McGraw-Hill Australia Pty Ltd

Positive Accounting Theory (PAT) (cont.)

Accounting numbers might be used as a means of

Copyright 2010 McGraw-Hill Australia Pty Ltd

Positive Accounting Theory (PAT) (cont.)

Copyright 2010 McGraw-Hill Australia Pty Ltd

Discussion leads to three main hypotheses of PAT that

Copyright 2010 McGraw-Hill Australia Pty Ltd

Selection of accounting methods can be explained by either