Chapter 2

Theories of financial accounting

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Objectives
Be able to describe various normative and positive

theories of financial accounting

Be aware of some of the limitations of the various
theories of accounting
Appreciate that there is no single unified theory of
accounting
Understand the various pressures and motivations
that might have an effect on the methods of
accounting selected by an organisation
Understand what is meant by creative accounting
and why it might occur

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Theory definition
A coherent group of propositions or principles forming

a general framework of reference for a field of inquiry

Accounting theories explain and predict accounting
practice (positive theories) or prescribe practice
(normative theories)

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Positive Accounting Theory (PAT)

Explains and predicts accounting practice

Does not seek to prescribe particular actions
Grounded in economic theory
Focuses on the relationships between various individuals
involved in providing resources to an organisation (agency
relationship)
Owners and managers
Managers and debt providers

(continues)

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Positive Accounting Theory (PAT)

(cont.)
Agency theory
Agency relationship

Delegation of decision making from the principal to the agent

Agency problem

Delegation of authority can lead to loss of efficiency and

increased costs

Agency costs

Costs that arise as a result of the agency relationship

(continues)

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Positive Accounting Theory (PAT)

(cont.)
Agency costs
Monitoring costs
Bonding expenditures
Residual loss

(continues)

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Positive Accounting Theory (PAT)

(cont.)
Assumptions of PAT
All individual action is driven by self-interest
Individuals will act in an opportunistic manner to increase their
wealth
Notions of loyalty and morality are not incorporated within the
theory
Organisations are a collection of self-interested individuals who
agree to cooperate

(continues)

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Positive Accounting Theory (PAT)

(cont.)
PAT predictions
Organisations will seek to put in place mechanisms
to align the interests of managers of the firm (agents)
with the interests of the owners (principals)
Some of these mechanisms rely on the output of the
accounting system

(continues)

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Positive Accounting Theory (PAT)

(cont.)
Efficiency and opportunistic perspectives of PAT
Efficiency perspective
Mechanisms are put in place up front with the objective of
minimising future agency costs
Referred to as ex ante perspective
Accounting methods adopted by firms best reflect the underlying
financial performance of the entity
Regulation is therefore argued to impose unwarranted costs on
reporting entities

(continues)

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Positive Accounting Theory (PAT)

(cont.)
Efficiency and opportunistic perspectives of PAT (cont.)
Opportunistic perspective

Considers opportunistic actions that could be taken once

various contractual arrangements have been put in place
Assumes managers will opportunistically select accounting
methods to increase their own personal wealth

(continues)

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Positive Accounting Theory (PAT)

(cont.)
Owner/Manager contracting
Managers assumed to act in their own self-interest
at the expense of owners

Rational economic person assumption

Managers have access to information not available

to principals

Information asymmetry

(continues)

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Positive Accounting Theory (PAT)

(cont.)
Owner/Manager contracting (cont.)
Methods of reducing agency costs of equity
Price protection
Monitoring by owners
Bonding by managers
Managers may be rewarded:

on a fixed basis
on the basis of the results achieved
on a basis that combines the two

(continues)

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Positive Accounting Theory (PAT)

(cont.)
Bonus schemes
Remuneration based on the output of the accounting system
Based on:
profits of the firm
sales of the firm
return on assets

May also be rewarded based on market price of shares

(continues)

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Positive Accounting Theory (PAT)

(cont.)
Accounting-based bonus schemes
Any changes in the accounting methods used by the
organisation will affect the bonuses paid (e.g. as a
result of a new accounting standard)
Contracts may rely on floating, generally accepted
accounting principles

(continues)

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Positive Accounting Theory (PAT)

(cont.)
Incentives to manipulate accounting numbers
Rewarding managers on the basis of accounting
profits can induce them to manipulate the related
accounting numbers to improve their apparent
performance and thus the related rewards
Accounting profits might not always provide an
unbiased measure of a firms performance

(continues)

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Positive Accounting Theory (PAT)

(cont.)
Market-based bonus schemes
Market prices are assumed to be influenced by
expectations about the net present value of
expected future cash flows
Cash bonuses might be awarded on the basis of
increases in share prices
Shares or options to shares might also be provided

(continues)

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Positive Accounting Theory (PAT)

(cont.)
Market-based bonus schemes
Market prices reflect market-wide factors, not just
those factors controlled by the manager
Only senior management will be likely to be able to
affect cash flows and hence securities prices

(continues)

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Positive Accounting Theory (PAT)

(cont.)

Role of auditor
If managers remuneration is based on accounting
numbers the auditor takes a monitoring role
The auditor arbitrates on the reasonableness of the
accounting methods adopted

(continues)

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Positive Accounting Theory (PAT)

(cont.)
Other mechanisms that align the interests of
managers and owners
Threat of takeovers to underperforming firms
A well-informed labour market

(continues)

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Positive Accounting Theory (PAT)

(cont.)

Debt contracting
Agency costs of debt:

excess dividends
claim dilution
asset substitution
investment in risky projects

It is assumed that the managers interests are aligned

with the shareholders interests

(continues)

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Positive Accounting Theory (PAT)

(cont.)
Ways to minimise the agency costs of debt
Price protection

Higher interest charges

Contracting

Interest coverage clauses

Debt to asset clauses

Leverage clauses frequently used in Australian bank loan

contracts

Monitoring
(continues)

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Positive Accounting Theory (PAT)

(cont.)
Political costs
Costs that groups external to the firm might be able to impose
on the firm:
increased taxes
increased wage claims
product boycotts
decreased subsidies

Organisations are affected by governments, trade unions,

environmental lobby groups or particular consumer groups

(continues)

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Positive Accounting Theory (PAT)

(cont.)

Political costs (cont.)

Demands placed on the firm might be affected by
accounting results

Higher reported profits

How accounting numbers are generated is not important

Accounting numbers might be used as a means of

providing excuses for effecting wealth transfers in

the political process

(continues)

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Positive Accounting Theory (PAT)

(cont.)
Ways to reduce political costs
Management might:

adopt income-reducing accounting techniques

make voluntary social disclosures

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PAT in summary

Selection of accounting methods can be explained by either

efficiency or opportunistic arguments
Accounting methods can impact on cash flows associated
with debt and management compensation contracts
These effects can be used to explain why particular
accounting methods are used
The use of particular accounting methods can have
conflicting effects

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Accounting policy selection

and disclosure
To allow comparison between reporting entities:

a summary of accounting policies must be presented in the

notes to the financial report (AASB 1001.6.1)
where an accounting policy has changed and the change
has a material effect on results the notes must disclose the
nature of, reason for, and financial effect of the change
(AASB 1001.6.2)

This requirement is consistent with SAC 3

(continues)

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Accounting policy selection

and disclosure (cont.)
Accounting policy choice and creative accounting
Creative accounting refers to selecting accounting
methods that provide the result desired by the
preparers
Also known as opportunistic
It is possible to be creative and still follow
accounting standards

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Criticisms of PAT

Does not provide prescription so does not provide a means of

improving accounting practice
Not value-free but rather value-laden
Underlying assumption of wealth maximisation
Issues being addressed have not shown any significant
development
Scientifically flawed

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Normative accounting theories

Seek to provide guidance in selecting accounting

procedures that are most appropriate

Prescribe what should be done

(continues)

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Normative accounting theories ( cont.)

The Conceptual Framework:
is considered a normative theory
seeks to identify the objective of 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

(continues)

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Normative accounting theories ( cont.)

Other normative theories

Three main classifications:

1.
2.
3.

current-cost accounting
exit-price accounting
deprival-value accounting

These theories addressed issues associated with changing

prices
Developed in 1950s and 1960s during a period of high inflation

(continues)

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Normative accounting theories ( cont.)

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)

(continues)

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Normative accounting theories ( cont.)

Exit-price accounting
Continuously Contemporary Accounting
Uses exit or selling prices to value the entitys assets and
liabilities

Referred to as current cash equivalents

Assumptions:
Firms exist to increase the wealth of their owners
The ability to adapt to changing circumstances
Capacity to adapt best reflected by current selling prices

(continues)

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Normative accounting theories ( cont.)

Deprival-value accounting
Deprival value represents the amount of loss that
might be incurred by an entity if it were deprived of
the use of an asset and the associated economic
benefits
This method considers:

the net selling price

the present value of future cash flows
an assets current replacement cost

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Systems-oriented theories
Systems-oriented theories
These theories focus on the role of information and
disclosure in the relationships between organisations, the
State, individuals and groups
The entity is assumed to be influenced by the society in
which it operates and to have an influence on it
Systems-based theories include:
Stakeholder Theory
Legitimacy Theory

(continues)

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Systems-oriented theories (cont.)

Stakeholder Theory

Two branches:
ethical (normative) branch
2. managerial (positive) branch
1.

Ethical branch

Stakeholders are any group or individual who can affect or are

affected by the achievement of the firms objectives
Includes shareholders, employees, customers, lenders,
suppliers, local charities, interest groups, government, etc.
All stakeholders have a right to be provided with information

(continues)

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Systems-oriented theories (cont.)

Stakeholder Theory (cont.)
Managerial branch
Seeks to explain and predict how an organisation will react to
demands of various stakeholders
Relative power or importance of stakeholders considered
Relative power and importance can change across time
associated with control of resources
The firm will take actions to manage its relationships with
stakeholders

(continues)

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Systems-oriented theories (cont.)

Stakeholder Theory (cont.)
Managerial branch (cont.)

Financial and social information is used to control conflicting

demands of various stakeholder groups

Stakeholder Theory (either branch) does not prescribe what

information should be disclosed, other than indicating that the
provision of information can be useful for the continued
operations of the entity

(continues)

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Systems-oriented theories (cont.)

Legitimacy Theory
Organisations continually seek to ensure that they operate
within the bounds and norms of society
Organisations attempt to ensure their activities are perceived to
be legitimate
Bounds and norms change across time
Based on a social contract between society and the
organisation

(continues)

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Systems-oriented theories (cont.)

Legitimacy Theory (cont.)
Organisations must appear to consider the rights of
the public at large, not just investors
To gain or maintain legitimacy, organisations might
rely on disclosure within their annual report

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Theories explaining why regulation

is introduced
Public interest theory
Capture theory
Economic interest group theory

(continues)

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Theories explaining why regulation is

introduced (cont.)
Public interest theory
Regulation put in place to benefit society as a whole
rather than vested interests
Regulatory body considered to represent the interests
of the society in which it operates, rather than the
private interests of the regulators
Assumes that government is a neutral arbiter

(continues)

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Theories explaining why regulation is

introduced (cont.)
Capture theory
The regulated seeks to take charge (capture) the
regulator
They seek to ensure rules subsequently released are
advantageous to the parties subject to regulation

(continues)

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Theories explaining why regulation is

introduced (cont.)
Economic interest group theory
Assumes groups will form to protect particular economic
interests
Groups are often in conflict with each other and will lobby
government to put in place legislation that will benefit them
at the expense of others
No notion of public interest inherent in the theory
Regulators (and all other individuals) deemed to be motivated
by self-interest
(continues)

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Theories explaining why regulation is

introduced (cont.)
Economic interest group theory (cont.)
The regulator is not a neutral arbiter but is seen as an interest
group
Regulator is motivated to ensure re-election or maintenance of
its position of power
Regulation serves the private interests of politically effective
groups
Those groups with insufficient power will not be able to lobby
effectively for regulation to protect their own interests

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Summary

The chapter describes various theories that relate to financial

accounting
No single accounting theory is universally accepted
A theory is defined as a coherent group of propositions used as an
explanation for a class of phenomena
Positive Theory of Accounting

Seeks to explain and predict accounting-related phenomena

E.g. study of capital markets reaction to particular accounting
policies, what motivates managers to select a given method of
accounting, reasons for the existence of particular accounting-based
contracts
Relies upon a fundamental assumption that individual action can
be predicted on the basis that all action is driven be a desire to
maximise wealth (a perspective often criticised by other
researchers)

(continues)

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Summary (cont.)
Normative theories of accounting

Prescribe how accounting should be practised

Argue typically that a central role of accounting theory is
to provide prescriptioninform about optimal accounting
approaches and why a particular approach is considered
optimal
Examples: Conceptual Framework Project, current-cost
accounting, exit-price accounting and deprival-value
accounting

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Summary (cont.)
Systems-based theories

Include Stakeholder Theory and Legitimacy Theory

See organisation as firmly embedded within a broader social
system
Organisation is considered to be affected by, and to affect,
the society in which it operates
Accounting disclosures are seen as a way to manage
relations with particular groups outside the organisation
organisational activities and accounting disclosures are
considered to be reactive to community pressureshow a
firm operates and what it reports must be determined upon
consideration of various stakeholder expectations

(continues)

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Summary (cont.)
Theories that seek to explain how regulation is
developed

Some theories suggest that regulation is introduced to

serve the public interest by regulators who work for the
public good
Other theories of regulation assume that the development
of regulation is driven by considerations of self-interest
Overall, the selection of one theory over another will
depend on the views and expectations of the researcher
in question
No one theory of accounting can be described as a best
theoryhowever, different theoretical perspectives can at
various times provide valuable insights in accounting
issues

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