ACC3100 WEEK 2

Accounting Theory a description, explanation or a prediction [of accounting practice] based

on observations and/or logical reasoning. Logical reasoning in the form of a set of broad
principles that provide a general framework of reference by which accounting practice can be
evaluated and guide the development of new practice and procedures
1. Type of theories

Normative Positive

definition Recommend what should Describes, explains or
happen; what ought to be predicts activities
Prescribe action to achieve Help us understand what
specific objectives happens in the world
Examples Conceptual framework Agency theory

Normative Theories recommend what should happen. Prescribe action to achieve specific
objectives. (e.g. The Conceptual Framework prescribes the objective of financial reports and
the qualitative characteristics of information)

Positive Theories describes, explains or predicts activities. Help us understand what happens
in the world. Based around Hypotheses Also called empirical theories. (e.g. Agency theory
claims that self-interests drive managers to engage in opportunistic financial reporting)

2.Positive accounting theory Based on the rational economic person assumption

Contracting Theory suggests that the organisation is characterised as a legal nexus of
contracts. (firm have contractual relationships with various parties)
Assumption: rational economic person (self-interest wealth maximization)
party
With contracting parties having rights and responsibilities under these contracts.
suggests that the organisation is characterised as a legal nexus of contracts

Agency Theory used to understand relationships whereby a principal employs the services of,
and delegates the decision making authority to, an agent.
Assumption: rational economic person (self-interest wealth maximization)
2.2 agency theory
2.21 agency cost Who bear? Description

Monitoring Shareholder The cost of shareholder to

monitor the manager

Eg: cost of prepare financial
statements
Bonding Managers Cost incurred by the
managers to assure that they
act for the interest of
shareholders


 eg: time and effort incurred by
managers to prepare more
frequent reports
Residual loss shareholders The cost suffered by the
shareholders due to the
suboptimal behaviour of
management that cannot be
eliminated by monitoring and
bonding


eg: misuse of business travel
expenses

Q: Explain any two agency problems between managers and shareholders.

Managers interests might differ from owners for a number of reasons, given both managers (agents) and
owners (principals) are assumed to act in their own interest, and these actions might not necessarily align.
Agency theory points to three main problems which highlight differences between interests of managers and
owners: the horizon problem (managers and owners have differing time horizons in relation to the entity);
risk aversion (managers generally prefer less risk than shareholders); and dividend retention (managers
prefer to maintain a greater level of funds within the entity, and pay less of the firms earnings to shareholders
as dividends).

The horizon problem exists because managers and owners have differing time horizons in relation to the
entity. Shareholders have an interest in the long-term growth and value of the entity as the share value of the
entity today reflects the present value of the expected future cash flows over the long-term. Managers, on
the other hand, are interested in the cash flow potential only as long as they expect to be employed by the
entity.

Risk aversion refers to the fact that managers generally prefer less risk than shareholders. Owners diversify
their risk through investing across multiple entities, and are also likely to receive income from other sources.
Managers have a large amount of human capital tied up in the entity and rely on the entity as their main
source of income. As such they are likely to be more risk averse than owners, and are less likely to want to
invest in risky projects. Managers prefer to maintain a greater level of funds within the entity, and pay less
of the firms earnings to shareholders as dividends. This is referred to as dividend retention. Managers wish
to expand the business they control, whereas shareholders wish to maximize the return on their investment
in the entity through increased dividends.

(dividend do not reduce profit, it only reduces cash and retained earning)

2.22 agency problem-----Manager-Shareholder

shareholder manager solutions
Horizon long-term growth and short term profit Give shares or options
future cash flow

 Link managerial pay to share
price movements

Risk Prefer risks Prefer less risk Profit based measurement
aversion than
shareholder Share based compensation
Dividend prefer receive prefer retain Link bonuses to dividend
retention dividend profit payout ratio

Link bonuses to profits
Claim dilution Increase borrowing from
higher priority debt can
reduce security to lenders

2.23 agency problem-----Manager-Lender

Q: Which specific agency problems associated with the relationship between lenders and the
firm can be controlled by specific covenants?
The four agency problems that exist in the relationship between lenders and managers are: excessive
dividend payments; underinvestment; asset substitution; and claim dilution.

When lending funds, lenders price debt to take account of an assumed level of dividend payout. Excessive
dividend payments, while good for shareholders, could lead to a reduced asset base securing the debt or
leave insufficient funds in the entity to service the debt.

Underinvestment arises when managers, on behalf of owners, have incentives not to undertake positive NPV
projects if the projects could lead to increased funds being available to lenders. This might particularly be
the case when the entity is in financial difficulty. Given creditors rank above owners in order of payments
in the event of liquidation, any funds form these projects would go towards debt rather than equity.

Managers have incentives to use debt finance to invest in alternative, higher risk assets in the likelihood that
it will lead to higher returns to shareholders. This is referred to as asset substitution. Lenders bear the risk
of this strategy as they are subject to the downside risk of this strategy but do not share in any upside
returns.

When entities take on debt of a higher priority than that on issue it is referred to a claim dilution. While
taking on additional debt increased funds available to the entity, it decreases security to lenders, making
lending riskier.

Excessive
dividend
payments Shareholders love dividend, so managers
distribute excessively
Lenders are concerned with firms paying too
much dividend: cash , asset, default risk
 Underinvestment debtor

Managers, on behalf of owners, have incentives
not to invest in positive NPV projects that can increase
funds available to lenders

Asset substitution
200 50% 15050%
shareholders
lender
downside
Managers choose riskier investment to maximize
shareholder returns
Lenders bear the downside risk, but do not share
upside benefits of such riskier investments (the
repayment to lenders is fixed)

Manager
lender
Claim dilution
Increase borrowing from higher priority debt can
reduce security to lenders
Solution

Debt covenant
definition A kind of Restrictions placed on borrowing by a lender
example limit borrowing and spending power
meet certain ratio (e.g. interest coverage ratio, gearing ratio, debt/asset
ratio)
keep certain level of cash
If default, immediate repayment
examples of liquidate / forced to sell assets
action work out a new agreement (renegotiation is costly)

Advantages Enable firms to raise funds

Make the loss of lending manageable
Increasing security and lenders trust (reducing agency costs of debt)
disadvantag Influence firm behaviour, e.g. manipulation of financial information,
es forced to sell assets to avoid default
Restrict investment activities

Institutional theory comes from management literature considers how rules,

norms and routines become established as authoritative guidelines, and considers how these
elements are created, adopted and adapted over time.( not important)

Legitimacy Theory base on the idea of a Social Contract. Relates to the explicit and implicit
expectations society has about how businesses should act to ensure they survive into the future.
Base on the idea of a Social contract ----Societys expectation about how
business should act


Organisations need to show they are acting in accordance with that expectation
legitimacy(Lindblom,1994) ( week 2 lectureS25 )

Stakeholder Theory considers the relationships that exist between the organisation and its
various stakeholders.
The normative branch of stakeholder theory relates to the ethical or moral treatment of
organizational stakeholders. It is argued that organizations should treat all stakeholders fairly,
and the organization should be managed for the benefit of all stakeholders.

Stakeholder theory
definition Considers the relationships that exist between the organisation and its
various stakeholders
Normative branch (ethical branch) Managerial branch
Manager shareholders Stakeholder
stakeholder The extent to which an organisation will
Argues that organisations should treat all consider its stakeholders is related to the
their stakeholders fairly. power or influence of those stakeholders.
An organisation should be managed for
Manager stakeholder
the benefit of all its stakeholders report

Q: Using stakeholder theory as your theoretical basis, explain why firms disclose information
to the general public. How about Legitimacy theory?

Stakeholder theory would explain these disclosures in terms of providing relevant information to
maintain relationships with powerful stakeholders.
Legitimacy theory sees voluntary disclosure as a way of maintaining or regaining legitimacy by
demonstrating how the entity is meeting societal expectations

The managerial branch of stakeholder theory is a positive theory that seeks to explain
how stakeholders might influence organizational action. Rather than considering each
stakeholder as equal (as is the case under the normative branch), the managerial branch
proposes that the extent to which an organization will consider its stakeholders is related to
the power or influence of those stakeholders, with executives managing these competing
interests.

Q: What are the factors a manager might consider in marking various expensing-capitalizing
choices?

Agency theory would propose that where a manager has discretion about the timing and the nature of
activities, they are likely to choose to expense or capitalize in order to maximize profits, which would lead
to increased bonuses to managers. It is also likely to ensure the entity is not close to breaching any debt
covenant that might be in place.

Q: What is the underlying assumption for positive accounting theory? Explain.

Used to explain and predict accounting practice.

Often used to explain choice of accounting policies or the decision to provide information

It examines a range of relationships between the entity and

suppliers of equity capital (owners),

managerial labour (management)

debt capital (lenders or debt holders)

Based on the rational economic person assumption

Incorporates contracting and agency theories

Q: What role does accounting information play in reducing agency problems?

Accounting information plays two roles in reducing agency problems. The first is where the terms
of managerial compensation or lending agreements are written in terms of accounting
information; and the second is where accounting information is used to determine performance
against the terms of the contracts.
2.24 Accounting information agency problems?
manager performance
stakeholder creditor
shareholder manager
Variety kinds of theories
Positive accounting Be used to explain and predict accounting
theory practice
It examines a range of relationships between
the entity
Based on the rational economic person
assumption
Contracting Theory Suggests that the organisation is characterised as a
legal nexus of contracts.
With contracting parties having rights and
responsibilities under these contracts.

Institutional theory It considers how rules, norms and routines become

established as authoritative guidelines, and considers
 how these elements are created, adopted and adapted
over time.
Legitimacy theory Organisations need to show they are operating in accordance
with the expectations in the social contract
Agency theory
Used to understand relationships whereby a principal employs the services of,
and delegates the decision making authority to, an agent.
(a) Using stakeholder theory as your theoretical basis, explain why firms disclose information to
the general public.

Stakeholder theory consider relationship between share holders & organizations:

1) normative theory: ethical branch, company should treat all shareholders fairly & the
organization should be managed for the benefit of all shareholders

2) positive theory: managerial branch, explain how shareholders might influence

organizational action rather than considering each stakeholder as equal. Organization
will consider its stakeholders power.

Providing information about organization performance & activities is one

important way to meet stakeholders need & expectation.

(a) Discuss why traditional financial reporting fails to meet the information needs of all
stakeholders.

Financial reporting is backward looking; focus on financial transactions; ignore externally

(e.g. pollution); ignore non-financial risk (e.g. customer risk).

(b) Outline the objectives of integrated reporting.

Increase the quality of information to providers of financial capital for making resource
allocation decision.

Increase the different communication that materially affect the ability of creating value
for an organization.

Increase accounting for 6 broad capitals & understanding of their interdependencies.

Increase integrated thinking, decision-making actions that focus on the creation of value
over the short, medium & long term.