ACCT5943

Accounting Theory

Learning Objectives
1. Nature & importance of accounting theory
2. Role of information economics in accounting

theory
3. Positive Accounting Theory (PAT) & its

implications for contracting & accounting

policy choice
4. Role of reputation in contracting & corporate
governance
5. Common normative & social systems
theories
6. Rationale for accounting regulation

Reading and lecture summary

Reference reading
Deegan, Chapter 3

Summary of lecture
Background on accounting theory
What and why?
Role of financial reporting in accounting theories
Entity and its stakeholders
Role of information economics in accounting theories
Introduction positive theory of accounting (PAT)
Other accounting theories
Normative accounting theories
Alternative theories systems oriented theories

What and why accounting

theory?
Coherent set of propositions or principles forming a
framework of reference for a field of enquiry
Concerned with predicting or explaining some
phenomena (a positive theory) or with prescribing a
course of behaviour (a normative theory).

Theories help us to

1. better understand the role of

accounting in society
2. adapt to the changing information
needs of society.

Stakeholders in an entity
Equity stakeholders
Participating (Management)
Non-participating

Debt stakeholders
Employees
Suppliers
Community
Note: Fundamental problem is how to best meet the
varying stakeholder needs
Focus of accounting theories is on the conflict between
management and other stakeholders

agency problem

Goal of general purpose financial

reporting
Develop and maintain efficient and effective
market for securities
Reduce information asymmetry
Access to common information by
participating and non-participating equity
stakeholders
Reduce adverse selection in the providing
financial data to users

Role of information
economics in accounting
Goal of accounting -> reduce information
asymmetry through the production of value relevant
information

Fundamental problem is how to best serve

different information needs

Two main types of information asymmetry:

1. adverse selection
2. moral hazard

Accounting & Adverse

Selection
Adverse selection -> the problem of inside
information
The user problem -> how to make rational
investment decisions in the presence of inside
information
Users demand -> full disclosure accounting &
reporting system

Accounting & Moral Hazard

action
Moral hazard -> the problem of
unobserved management effort
The user problem -> how to provide incentives &
monitoring mechanisms to ensure that managers
maximise effort in meeting goals
Users demand -> an accounting system that
produces reliable/verifiable information (hard
numbers)

Mediation & Regulation

Sub-optimal production of information
Conflicting information demands leads to a
demand for mediation in the form of
Professional regulation (Code of
Professional Practice, Auditing standards)
Statutory regulation
(e.g. accounting & auditing standards,
Corporations Act, etc.)

Financial Accounting & Information Asymmetry

Note: Australian
equivalent is ASIC, AASB

Source: Scott, W. Financial Accounting Theory, Prentice Hall, 1997,p.6.

Positive Accounting Theory (PAT)

http://www.slideshare.net/khosru/accounting-theory-9

Attempts to explain and predict the incentives for and

economic consequences from the adoption of alternative
accounting policies

Including
the demand for accounting information
motivations for accounting changes
lobbying behaviour on accounting regulation
share price reaction to accounting changes

Agency theory origins of PAT

A principal-agency relationship arises from
separation of ownership and management

The 2 major principal-agent relationships

are between:
(1) shareholders & managers
(2) debtholders & shareholders

Agency Costs
Agency costs arise in attempt to minimise the moral
hazard problem
Jensen and Meckling (1976) distinguish two types of
agency costs that arise in the absence of agency
resolution mechanisms:

1. Agency costs of equity

2. Agency costs of debt

1. Agency

Costs of Equity

Firm value reduced by management acting in its own

interests at expense of shareholders, including:

risk aversion
differences over decision horizons
dividend retention
excessive perquisite consumption
shirking
fraud

Agency Costs of Equity

- Resolution Mechanisms
Management compensation (bonus) plans
Managerial labour market (external & internal)
Auditing (external & internal)
Corporate governance practices & policies (audit
committees, independent directors, etc.)
Market for corporate control
Product markets

2.Agency

Costs of Debt

Shareholders have incentives to maximise value of

equity rather than total value of firm (debt & equity),
including:

payment of excessive dividends

debtholder claim dilution
asset substitution
underinvestment
Excessive management perquisites / shirking can
also be considered an agency cost of debt if it leads
to debt default.

Agency Costs of Debt

- Resolution Mechanisms
Agency costs of debt
Restrictive covenants
Monitoring (through the production of general
and specific financial reports
Debtholder representation on board of
directors and other committees (Corporate
governance in place)

Agency Costs Arising from

Resolution Mechanisms
Agency costs arise in attempt to minimise the
moral hazard problem, including:
bonding costs (e.g costs of preparing
periodic reports)
monitoring costs (e.g. auditing costs)
residual loss costs (the deadweight loss)
(Jensen & Meckling, 1976)

Other Contracting Costs Political Costs

Costs associated with the
power of government or regulatory
agencies or
interest groups
to effect wealth redistributions between
firms and/or other parties in society

Typically in the form of taxes, quotas,

subsidies, licences, price support schemes.

Role of Accounting in
Contracting and Monitoring
Contracts are written using accounting numbers
Reported financial information used to monitor (implicit
and explicit) contracts
Not all accounting methods can be specified in
contracts (i.e. managers have some discretion - there is
some residual loss)

=> Accounting method choice has

economic consequences

PAT & Accounting policy

choice predictions
Watts & Zimmerman (1986) hypotheses:
(1) Bonus Plan
- Managers adopt income increasing methods where
there is a link between compensation plans and
accounting numbers

(2) Debt covenant

- Managers adopt income increasing accounting
methods where debt contracts specify covenants
linked to accounting numbers

(3) Political Cost

- Large firms prefer income decreasing methods to
minimise political costs

Economic consequences of
accounting policy choice
Managers have incentives to adopt certain accounting
policies, two perspectives:
Opportunistic

managers choose accounting methods that

maximise their own welfare
Contracting Efficient

managers choose accounting methods that

maximise firm value (minimise agency costs)

Other influences on
accounting policy choice
Contracting Incentives

GAAP

Either opportunism or
contracting efficiency

Accounting Policy Choice

Market Forces

Signalling Incentives

Summary of PAT
Firm level
Agency relationships
(Mgrs./Sholders,
Sholders/Debtholders)

Agency costs
(Debt/Equity)

Society level
Firm/Society
relationship

Political costs

Due to Info.
Asymmetry

Contracts (Explicit or Implicit)

Accounting Policy Choice

(Where contract terms are based on accounting data)

Normative Accounting Theories

Seek to provide guidance to select accounting
procedures which are most appropriate
Prescribes what should be done
Examples:

Conceptual Framework
The True Income theories
e.g. CCA, CoCoA, Deprival Value
accounting

Normative accounting theories

The Conceptual Framework (CF):
is considered a normative theory
seeks to identify the objective of general purpose
financial report (GPFR)
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

Normative accounting theories

The Conceptual Framework (CF): (continued)
CF is a constitution or blueprint for standard setting
CF aims to make accounting standards consistent with
each other and based on the same set of underlying
concepts
Australian CF was reissued and took effect on 1 Jan
2005 to comply with the International Accounting
Standards Boards (IASBs) CF

Normative accounting theories

The Conceptual Framework (CF): (continued)
Identical recognition tests: probable occurrence and
reliable measurement
Qualitative characteristics: Both have relevance,
reliability, comparability, understandability,
materiality; IASBs CF also has prudence, faithful
representation, substance over form, neutrality,
completeness, timeliness, balance between benefits
and costs.
Measurement: IASBs CF covers this but is very
permissive; Australian CF did not cover it.

Normative accounting theories

The Conceptual Framework (CF): (continued)
Compliance with CF by Australian companies is not
mandatory
Conflicts between standards and CF mean that the
standards should be revised, but meanwhile the
standard prevails
If there is no AASB or UIG, then CF is to be used
next in selecting a/c policies (AASB 1001 [4.1.2])
CF is not perfect and may need to be revised in
future (IASBs Sir David Tweedie)

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Normative accounting theories

Other examples of normative theories
Three main classifications:
1.
2.
3.

Current-cost accounting
Deprival-value accounting
Exit-price accounting (CoCoA)

These alternative accounting theories addressed

issues associated with changing prices
Developed in 1950s and 1960s during a period of
high inflation some features are still observed at
present

Normative accounting theories

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)
Provide more accurate picture of current operating
efficiency

Normative accounting theories

See Lecture Illustration 1: Current cost
accounting in Lecture Handout (file available in
WebCT Vista)
Consider: How useful is Current Cost Accounting
in making business decisions?

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Lecture Illustration 2
Example of deprival value

Replacement Cost
Deprival
Value

Lower of
The higher of

NPV
NRV

Taken from: Godfrey, Hodgson, Holmes & Tarca (2003)

Normative accounting theories

Exit-price accounting
Also know as Continuously Contemporary
Accounting (CoCoA)
Uses exit or selling prices to value the entitys assets
and liabilities
Referred to as current cash equivalents

The CoCoA system

Developed by R.J. Chambers, an Australian, in 1966.

Relevance of CoCoA in 2005?

Some of its features have been adopted in recent
standards, e.g. AASB 121/129 (foreign currency
transactions), AASB 141 (SGARAs); AASB 1038 (life
insurance); AASB 116/138 (fair values for non-current
assets); AAS 25 (superannuation plans); AASB139
(Financial Instruments)

Key Features of CoCoA:

All assets and liabilities are valued at their current cash
equivalents (net market selling prices in an orderly
market; not fire sale prices)
Changes in asset or liability values go direct to the
Income Statement
Assets must be able to be sold separately. Severability is
an essential characteristic of an asset (unlike SAC 4). So
goodwill is not an asset in the CoCoA system.
Share capital is adjusted upwards for any inflation
CoCoA is scientific in that it is a complete logically
derived theory which is based on a number of underlying
assumptions
Illustration 3

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Key assumptions underlying

CoCoA
Adaptation to changing circumstances is the
dominant mode of economic behaviour
Rational behaviour
People or organisations operate as a homeostatic
system, one which adapts continuously to changing
circumstances
Each persons behaviour is subject to his/her
capacities, information search costs etc
The firm is a going concern

Theory Contribution
Normative Theories ->
Provide direction & guidance to standard
setting/practice, e.g.
Move towards current cost accounting
Adoption of conceptual framework
Appreciation of social responsibility

Positive accounting theory ->

Understanding & acceptance of economic
consequences of accounting methods, e.g.
cost/benefit test incorporated into IASB
Framework

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