GODFREY

HODGSON
HOLMES
TARCA

CHAPTER 11
POSITIVE THEORY OF ACCOUNTING
POLICY AND DISCLOSURE
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

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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
agents 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)
agents 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 firms 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
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

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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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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

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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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Key terms and concepts
Shareholder/manager agency problem
Shareholder/debtholder agency problem
Excessive dividend payment problem
Asset substitution problem
Underinvestment problem
Claim dilution problem
Ex post opportunism
Ex ante efficient contracting
Signalling theory
Political processes
Conservatism

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