Chapter 5

Theories in accounting

©2018 John Wiley & Sons Australia Ltd

 Learning objectives

After studying this presentation, you should be able to:

5.1 evaluate how theories can enhance our
understanding of accounting practice
5.2 integrate knowledge about positive accounting
theory and agency theory and apply them to agency
contracts between owners, managers and lenders to
explain accounting practice and disclosure
 Learning objectives

5.3 evaluate institutional theory in terms of its

application to organisational structures and apply
the theory to accounting practice and disclosure
5.4 evaluate legitimacy theory and the notion of the
social contract and apply it to accounting
practice and disclosure
 Learning objectives

5.5 evaluate stakeholder theory and apply it to

accounting disclosure
5.6 evaluate contingency theory in terms of its
application to accounting practice and disclosure.
Presentation overview
 What value does theory offer?

• Accounting involves more than recording financial

transactions according to a set of rules or standards.
• Accounting theories help us understand:
– What appropriate methods should be used.
– How accounting information should be measured
and reported.
– The decisions of financial information preparers.
– How organisational systems and controls are
contingent on both external and internal factors that
affect the organisation.
 Types of theories

• Two main types of theories are used in

accounting:
1. Normative theories:
• Not necessarily based on what is happening,
but instead recommend what should happen.
• Prescribe action required to attain a specific
goal.
• E.g. Conceptual Framework.
 Types of theories

• Two main types of theories are used in accounting:

2. Positive theories:
• Describe, explain, or predict activities based
on real world observations.
• Help us understand why decisions have been
made.
• Lead to more informed decision making.
• E.g. contracting theory and agency theory.
 Positive accounting theory

• Contracting theory:
– Suggests that an organisation is characterised as a
legal ‘nexus of contracts’.
– Ownership and control are separate and
contractual managers are appointed by owners.
– Managers contract with lenders on behalf of
owners to obtain debt funding.
– Both managerial and debt contracts are used to
manage these agency relationships.
 Positive accounting theory

• Agency theory:
– Used to understand relationships whereby a
principal employs the services of an agent to
perform some activity on their behalf and delegates
the decision making authority to the agent.
– Can create a moral hazard if the interests of the
agent and principal are not aligned.
– There are three costs are associated with relying on
an agent to make decisions and conduct the
business.
 Positive accounting theory

1. Monitoring costs:
– Are incurred in measuring, observing and
controlling the agent’s behaviour and include:
• auditing of financial reports
• setting up operating rules
• establishing a management compensation
plan.
– These costs are likely to be lower for an agent with
a good reputation.
 Positive accounting theory

2. Bonding costs:
– Are incurred installing mechanisms to assure that
agent’s decisions are in the best interest of the
principals. For example:
• Incurring the time and effort involved in producing
and providing quarterly accounting reports to
lenders.
• Managers might also agree to not provide
information to some external parties who may gain
a competitive advantage from it.
 Positive accounting theory

3. Residual loss:
– Estimated monitoring and bonding costs are borne
by agents through reduced remuneration (in a
managerial contract) or higher interest rates (in a
debt contract).
– Divergence from these estimates is referred to as
residual loss.
– Residual loss is borne by both the principal and
the agent.
 Positive accounting theory

• Owner–manager agency relationships:

– Agency theory identifies a number of problems
that can exist between managers and owners in an
agency relationship, including the horizon
problem, risk aversion and dividend retention.
– Contracts and accounting information can be used
to ‘bond’ the interests of owners and managers to
reduce these problems.
 Positive accounting theory

1. Horizon problem:
– Managers and owners (shareholders) tend to have
differing time horizons in relation to the entity.
– Linking management rewards to the longer term
performance of the entity reduces this problem.
– Moving the manager’s focus from short‐term
profitability to longer term activities, designed to
improve future cash flows, encourages managers
to focus on long-term performance.
 Positive accounting theory

2. Risk aversion:
– Managers are more risk averse than shareholders.
– Increasing managerial share ownership increases a
manager’s risk aversion as it further decreases a
manager’s ability to diversify risk.
– Remunerating managers with a mix of cash and
shares and limiting the share‐based compensation as
a manager’s ownership in the company increases, is
likely to encourage managers to invest in more risky
opportunities.
 Positive accounting theory

3. Dividend retention:
– Managers prefer to maintain a greater level of
funds within the entity, and pay less of the entity’s
earnings to shareholders as dividends.
– Linking bonuses to dividend payout ratios will likely
encourage managers to enhance dividend payouts
to shareholders.
– Linking bonuses to profits will encourage managers
to seek additional profits, which are likely to be
available for dividends.
 Positive accounting theory

• Manager–lender agency relationships:

– When a lender agrees to provide funds to an
entity there is the risk that the borrower may not
repay those funds.
– In this instance the manager’s interests are
completely aligned with owners.
– The agency problems that could arise include
excessive dividend payments to owners,
underinvestment, asset substitution and claim
dilution.
 Positive accounting theory

1. Excessive dividend payments:

– When lending funds, lenders price the debt to
take into account an assumed level of dividend
payout.
– If managers issue a higher level of dividends, or
excessive dividend payments, then this could
lead to a reduction of the asset base securing
the debt, or leave insufficient funds within the
entity to service the debt.
 Positive accounting theory

2. Underinvestment:
– The problem arises when managers, on behalf of
owners, have incentives not to undertake positive
net present value (NPV) projects if the projects
would lead to increased funds being available to
lenders.
– Covenants that specify the investment
opportunities for which the organisation is able to
use the funds are likely to alleviate this problem.
 Positive accounting theory

3. Asset substitution:
– Investment in alternative, higher‐risk assets may
lead to higher returns to shareholders.
– Lenders bear the risk of this strategy.
– Debt contracts often restrict the investment
opportunities of the entity.
– The lender might also secure the debt against
specific assets.
 Positive accounting theory

4. Claim dilution:
– When entities take on debt of a higher priority
than that on issue it is referred to as claim
dilution.
– The most common method of avoiding claim
dilution is to restrict the borrowing of higher
priority debt, or debt with an earlier maturity
date.
 Positive accounting theory

• Role of accounting information in reducing agency

problems:
– Accounting information forms one of the major
components of both manager remuneration and
lending contracts.
– For managers accounting information plays two
roles in the contracting process:
1. Writing the terms of managerial contracts.
2. Determining performance against the terms of
the contracts.
 Positive accounting theory

• Information asymmetry:
– Results when managers have an advantage over
investors and other interested parties because they
have more information about the current and
future prospects of the entity.
– Managers can choose when and how to disseminate
this information.
 Positive accounting theory

• Information asymmetry:
– If entities did not provide information when other
entities in the market did so, it would be assumed
they had bad news to report and their share price
would suffer as a result.
– This is referred to as adverse selection.
 Institutional theory

• Institutional theory:
– It has been used extensively in management
literature and is increasingly used in accounting
research to understand the influences on
organisational structures.
– It considers how rules, norms and routines
become established as authoritative guidelines,
and considers how these elements are created,
adopted and adapted over time.
 Institutional theory

• Institutional theory:
– It proposes three main areas of influence, which
leads to similarities across jurisdictions,
organisational fields and organisations, referred to
as isomorphism.
 Institutional theory

• Institutional theory:
– Isomorphism:
1. Coercive isomorphism refers to pressures to
conform to public expectations and demands.
2. Mimetic isomorphism refers to the tendency to
imitate other organisations viewed as successful.
3. Normative isomorphism emphasises the
collective values and beliefs that lead to
conformity of actions within institutional
environments.
 Legitimacy theory

• Legitimacy theory:
– Used to understand corporate action and activities,
particularly relating to social and environmental
issues.
– Based on social contracts.
 Legitimacy theory

• Social contracts:
– Society’s explicit and implicit expectations regarding
the way businesses should act to ensure their
survival.
– Organisations need to show they are operating in
accordance with the expectations in the social
contract.
 Legitimacy theory

• Organisational legitimacy:
– Explains the process by which the social contract
between business and society is maintained.
– Argues that organisations can only continue to exist
if the society in which they operate recognises they
are operating within a value system that is
consistent with society’s own.
– Organisation must appear to consider the rights of
the public at large, not just its shareholders.
 Legitimacy theory

• Accounting disclosures and legitimation:

– There are four ways an organisation can obtain or
maintain legitimacy:
1. Educate and inform society about actual
changes in the organisation’s performance and
activities.
2. Change the perceptions of society, but not
actually change behaviour.
 Legitimacy theory

• Accounting disclosures and legitimation:

3. Manipulate perception by deflecting attention
from the issue of concern to other related
issues.
 Legitimacy theory

• Accounting disclosures and legitimation:

4. Change expectations of its performance.
– Legitimation can occur through
performance, or through disclosure.
– The strategies taken by entities are going to
differ depending on whether they are trying
to gain, maintain existing or repair lost or
threatened legitimacy.
 Legitimacy theory

• Accounting disclosures and legitimation:

4. Change expectations of its performance.
– Disclosure of information about an
organisation’s effect on, or relationship with,
society can be used in each of the strategies.
• An entity might provide information to
offset negative news which may be
publicly available.
 Legitimacy theory

• Accounting disclosures and legitimation:

4. Change expectations of its performance.
– Disclosure of information about an
organisation’s effect on, or relationship with,
society can be used in each of the strategies.
• Organisations may draw attention to
strengths, while playing down
information about negative activities.
 Legitimacy theory

• Accounting disclosures and legitimation:

4. Change expectations of its performance.
– Public reporting through the annual report or
the entity website can be a powerful tool in
showing that an organisation is meeting the
expectations of society.
– One of the major functions of corporate
reporting is to legitimate corporate
operations.
 Legitimacy theory

• Accounting disclosures and legitimation:

4. Change expectations of its performance.
– Legitimacy theory has commonly been used
to explain disclosure of sustainability or
corporate social and environmental
information.
 Stakeholder theory

• Stakeholder theory considers the relationships that

exist between the organisation and its various
stakeholders, rather than society as a whole.
• It relates to the ethical or moral treatment of
organisational stakeholders.
• Stakeholders are individuals or groups who are
affected by, or can affect, the achievements of an
organisation’s objectives.
 Stakeholder theory

• Organisational stakeholders:
 Stakeholder theory

• Stakeholder theory is not limited to profit‐generating

entities, it can be applied to non‐profit businesses,
including charities.
• Characteristics of entities to which stakeholder theory
can apply:
– Voluntary associations:
• formed to realize specified aims and purposes.
• that allow members to freely exit (and freely eject
other members from) the association.
 Stakeholder theory

• Characteristics of entities to which stakeholder theory

can apply:
– Voluntary associations:
• that attract and retain (as well as recruit and
evaluate) members on the basis of their interest in
advancing the association’s objectives.
– For‐profit entities need to generate profits for
shareholders and other financiers, non‐profit entities
do not.
 Stakeholder theory

• Characteristics of entities to which stakeholder

theory can apply:
– Shareholders might sell their shares in profit‐
generating entities, while donors may decide
whether or not to donate to a non‐profit entity.
– Both entities allow employees to freely leave.
 Stakeholder theory

• Our understanding of stakeholder theory has changed

over the past five to ten years.
• The literature previously suggested that three
branches of the theory existed:
– a normative theory, or ‘ethical branch’
– an instrumental branch
– a descriptive or positive branch, often referred
to as the managerial branch.
 Stakeholder theory

• It was proposed that organisations should treat all

their stakeholders fairly and an organisation should be
managed for the benefit of all its stakeholders.
• It was was proposed as a mechanism to explain how
stakeholders might influence organisational actions.
• At times there will likely be conflicting interests, so it
fell on management to partially sacrifice the interests
of shareholders to meet those of other stakeholders.
 Stakeholder theory

• Role of accounting information in stakeholder

theory:
– One important way of meeting stakeholders’
needs and expectations is providing information
about organisational activities and performance.
– As with legitimacy theory, stakeholder theory has
been used to examine disclosure of voluntary
information to stakeholders, most commonly
relating to social and environmental performance.
 Contingency theory

• Contingency theory proposes that organisations are

all affected by a range of factors that differ across
organisations.
• Organisations need to adapt their structure to take
into account a range of factors such as:
– external environment
– organisational size
– business strategy.
 Contingency theory

• Contingency frameworks have been used to evaluate

management accounting information and internal
control systems.
• They conclude that:
– There is no universally appropriate accounting
system that can be applied to all organisations.
– Features of appropriate accounting systems are
contingent upon the specific circumstances the
organisation faces.
 Contingency theory

• Comparison of theories:
 Using theories to understand
accounting decisions

• Accountants use judgement to make a range of

accounting decisions on a daily basis, including:
– Whether to expense or capitalise costs.
– What accounting estimates to use.
– Whether to recognise an item in the body of the
financial statements, or disclose it in the notes only.
– Whether to disclose additional information, where it
is not governed by legislation.
• Accounting theories offer some assistance in explaining
managers’ and accountants’ decisions.
 Using theories to understand
accounting decisions
• Expensing and capitalising costs:
– Agency theory:
• Managers with bonuses linked to a current
measure of entity performance, like profits, will
aim to maximise profits.
• Where the entity has a lending agreement with a
leverage covenant, managers will want to ensure
the value of assets is maximised, which will lead
to capitalising costs where possible.
 Using theories to understand
accounting decisions
• Expensing and capitalising costs:
– Institutional theory:
• Explains the influence of external norms and
expectations on managerial compensation policy.
• Entities would be expected to follow industry
practices that are perceived as ‘normal’, in setting
pay and using a mix of cash and incentive pay.
 Using theories to understand
accounting decisions

• Accounting estimates:
– Accountants and managers constantly estimate
economic magnitudes to bring to account.
– Estimates can lead to substantial variations in
reported profits and asset balances.
– Agency contracts can explain managerial decisions
as managers and accountants are likely to ensure
their own bonuses are maximised and the entity is
not at risk of breaching debt contracts.
 Using theories to understand
accounting decisions

• Disclosure policy:
– Beyond the specific standard and legal requirements,
managers and accountants decide the extent and
location of voluntary disclosures within the annual
report.
– In stakeholder theory, these disclosures help to
maintain relationships with powerful stakeholders.
– In legitimacy theory, they are a way of maintaining or
regaining legitimacy.
 Summary

• How theories can enhance our understanding of

accounting practice.
• Positive accounting theory and agency theory and
there application to agency contracts between
owners, managers and lenders (to explain accounting
practice and disclosure).
• Institutional theory in terms of its application to
organisational structures and its application to
accounting practice and disclosure.
 Summary

• Legitimacy theory and the notion of the social

contract and it application to accounting practice and
disclosure.
• Stakeholder theory and its application to accounting
disclosure.
• Contingency theory and its application to accounting
practice and disclosure.
• The different decisions made by accounting
practitioners, and how theories can be used to explain
a range of decisions.