Prepared by Arabella Volkov

University of Southern Queensland

 References
• Text – Chapter 10

A positive theory
of accounting discretion
 Learning Objectives

At the conclusion of this lecture, you

should have an appreciation of:
• Why the firm can be described as a
‘nexus of contracts’
• How accounting is used in
contractual specifications to reduce
the agency costs of equity and debt
 Learning Objectives

At the conclusion of this lecture, you

should have an appreciation of:
• How managers’ ex post accounting
decisions can transfer wealth from
shareholders to managers
• How price protection and ex post settling
up by shareholders and lenders constrain
opportunistic reporting by managers
 Learning Objectives
At the conclusion of this lecture, you
should have an appreciation of:
• How managers’ ex post accounting
decisions can transfer wealth from lenders
to equityholders
• The difference between ex post
opportunism, efficient contracting and the
information perspectives of accounting,
and how signalling theory relates to each
perspective
 Learning Objectives

At the conclusion of this lecture, you

should have an appreciation of:
• How accounting can be used to
signal information about the firm
• How accounting can be used to reduce
the political costs faced by the firm
• Key criticisms of positive theories of
accounting choice, and their validity
 Background: Early Demand
for Theory
• Capital markets research inconclusive
• Observations of accounting policy choice
– Why do managers prepare financial
reports?
– How are accounting policy choices
made?
• Information hypothesis could not explain all
observations
 Contracting Theory

• The firm as a legal ‘nexus’ of

contractual relationships
• Organising economic activity to
reduce contracting costs
– management contracts
– debt contracts
 Agency Theory
• Jensen & Meckling (1976)
• Contract where one party (the principal)
engages another (the agent) to act on their
behalf
– e.g. where there is a separation of
management and control. Managers have
remuneration contracts
• Utility maximisation by both parties
– Agent may act on her/his own behalf (self-
interest)
 Agency Theory
• Firms can be characterised as a nexus
of contracts
– Between consumers of products and
the suppliers of factors of production
• Firms exist because they reduce
contracting costs,
– Firms provide an efficient means of
organising economic activity
• Contracts include all types of
agreements between two or more parties
 Agency Theory
Agency costs
– Due to self interest, the agent might
act in his/her own interest rather than
that of the principal (moral hazard)
– Agents may undertake certain
Divergent Behaviours
– This agency problem gives rise to
Agency Costs (monitoring, bonding
and residual loss)
 Agency Theory
Agency costs can be categorised into:
1. Monitoring Costs – the cost of
observing the agent’s behaviour
• Auditing costs
2. Bonding Costs – Costs borne by the
agent (e.g. manager) as a result of
aligning their interests with the principal
(e.g. owners)
• Manager has to prepare financial reports
(a cost to the manager in terms of time
and effort)
 Agency Theory

Agency costs can be categorised into

(continued):

3. Residual Loss – loss associated with

not being able to fully align the interests
of the principal with the agent
 Agency Theory

Price Protection (ex ante – up front)

• The principal reduces the remuneration paid to
the agent in anticipation of agency costs
• Cost of dysfunctional behaviour built into
remuneration
Ex post settling up (ex post – after the fact e.g. at
the end of each year)
• The principal reduces the remuneration paid to
the agent
• Remuneration based on observed agent
performance
 Manager-Shareholder
Agency Relationships
• Managers as agents of owners can act in
own interest
• The smaller the manager ownership in the
firm the more likely divergent behaviours
• Manager has incentive to contract with firm
to reduce divergent behaviours to reduce
price protection
• Manager bear cost of owner monitoring
 Manager-Shareholder
Agency Relationships
Agency Costs of Equity
 Risk-Aversion – limited incentive to
increase value of firm through investment
in risky projects
 Dividend Retention – reduced incentive
to pay dividends or take on optimal levels
of debt
 Horizon Problem – short term focus on
performance of firm
 Over-consumption of Perquisites
 Manager-Shareholder
Agency Relationships
Reducing the agency costs of equity
• Bonuses are usually tied to firm
performance in some way to motivate
managers to act in the owners’ interest
• Bonuses can be paid in cash and/or
shares/share options
Bonuses can be tied to:
1. Accounting numbers(such as net income,
sales, return on assets)
2. Share price (market based performance
measure)
 Shareholder-Debtholder
Agency Relationships
Agency costs of debt
1. Excessive dividend payments-reducing
debtholder’s security
2. Asset substitution-firm invests in higher
risk projects (no benefit to debtholder)
3. Under investment-where no incentive to
invest in positive NPV projects
4. Claim dilution-issuing higher priority debt
 Shareholder-Debtholder
Agency Relationships
• Debt-holders can Price Protect via increased
interest charges or reduced amounts provided
• The interests of shareholders can be bonded
to those of debtholders via restrictions in
lending agreements (Loan Covenants)
• Covenants often rely on numbers contained in
financial statements
• Covenants usually restrict the behaviour of
managers acting on behalf of owners
 Ex post Opportunism versus
Ex ante Efficient Contracting
• Contracts provide incentives for
agents to act against principals
interest
Opportunistic perspective
– ex post (after contracts finalised)
– incomplete contracts
– bonus plan hypothesis
– debt-equity hypothesis
• Efficient contracting perspective
 Ex post Opportunism versus
Ex ante Efficient Contracting
Efficient contracting perspective
• Efficient contracts align interests of
agent with principal
• Actions that benefit agent also
benefit firm
• Ex ante – before contracts are
finalised
 Information Perspective
and Signalling
• Holthausen
• Derived from signalling theory
• Managers provide information to
investors to assist in their decision
making
• Similar to efficient contracting
• Accounting information precedes
cash flows
 Information Perspective
and Signalling
• Aligned with the information
hypothesis
• Managers use the accounts to signal
expectations and intentions regarding
the future
• Incentives to signal good, neutral and
bad news
 Political Processes
• The firm and parties interested in the firm
• Political market v. capital market
– Less demand for information in political
market
– Less benefit from information gathering
– Heterogeneity of interests
 Political Processes
• Political costs – wealth transfers
– Size hypothesis
• Implications for firm behaviour
– e.g. banking sector in Australia
 Empirical Tests

Testing the opportunistic and political

cost hypothesis
– Watts & Zimmerman
– Zmijewski & Hagerman
– provided little insight
 Empirical Tests
Empirical tests – tests using contract details
(Healy)

Figure 10.1: Allocation of funds to the bonus pool,

based on accounting profit
 Empirical Tests
Empirical tests – tests using contract details
(Healy)

Figure 10.2: Accounting accruals as a function of

bonus plan specifications
 Empirical Tests
Refining the specification of political
costs
– Liberty & Zimmerman
– Godfrey & Jones
– DeAngelo
– Wong
– Lemke & Page
– Panchapakesan & McKinnon
– Ali & Kumar
 Empirical Tests

Tests of efficient contracting hypotheses

– interest capitalisation
– voluntary consolidated financial
reporting
– changes in CEO
– other studies
 Evaluation of the Theory

Methodological and statistical criticisms

– empirical evidence weak and
inconclusive
– McKee, Bell & Boatsman
– Christie
– Leftwich
 Evaluation of the Theory

Philosophical criticisms
– Tinker, Merino and Neimark
– Christenson
– Watts and Zimmerman
 Summary
• Positive accounting theory has been
a major force in accounting research
for 20 years
• Researchers argue they have tried to
develop a theory that has an
information role
• Positive accounting theory continues
to develop
 Key Terms and Concepts

• Positive theory
• Accounting choice
• Empirical and theoretical
• Hypotheses
• Methodological
• Contracting theory
• Agency theory
 Where to get more
information
• Other courses
• List books
• Articles
• Electronic sources