Chapter 3
Theories of financial
accounting
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PPTs to accompany Deegan, Australian Financial Accounting 7e
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Objectives of this lecture
• Understand what constitutes a theory and
appreciate why students of financial accounting
should know about various theories of accounting
• 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
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Objectives of this lecture (cont.)
• Understand the various pressures and motivations
that might have an effect on the methods of
accounting selected by an organisation
• Understand that the choice of alternative accounting
policies can be explained from either an ‘efficiency
perspective’ or from an ‘opportunistic perspective’
• Understand what is meant by ‘creative accounting’
and why it might occur
• Understand that there are theories that explain why
regulation—such as accounting regulation—is
introduced
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Why do we bother discussing
theories when we are studying
financial accounting?
• Discuss the requirements of the various accounting
standards and to provide frameworks to consider the
implications of organisations making particular
accounting disclosures
• Consider the various pressures that influence the
accounting standard-setting environment that
theories provide a basis in understanding
• To gain a greater understanding of the implications
of various accounting standards and other disclosure
requirements
• Explores the various pressures on regulators
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Theory definition—what is a
theory?
• A coherent group of propositions or principles
forming a general framework of reference for a field
of inquiry
• Accounting theories often:
– explain and predict accounting practice (referred to as
positive theories) or
– prescribe particular practice (referred to as normative
theories)
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Positive Accounting Theory (PAT)
• Positive Accounting Theory is an example of a
positive theory of accounting.
• PAT explains and predicts accounting practice
• PAT does not seek to prescribe particular actions
• It is grounded in economic theory
• It focuses on the relationships between various
individuals involved in providing resources to an
organisation (agency relationship)
• PAT was developed, in part, from another theory
known as agency theory. Agency theory discusses
agency relationships, problems and costs
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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 to the extent it
is in their interest
• Certain contractual agreements will be put in place
in an endeavour to align the various interests and
many of these contracts rely upon accounting
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Positive Accounting Theory (PAT) (cont.)
PAT predictions:
• To try to improve efficiency, organisations will seek
to put in place mechanisms to align the interests of
managers of the firm (the agents) with the interests
of the owners (principals)
• Some of these mechanisms rely on the output of the
accounting system
– For example, owners might agree to pay a manager a
bonus based on a specified percentage of profits
– Thereafter, both the manager and the owner will have
their interests aligned as both will prosper from an
increase in profits
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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
•
Opportunistic perspective
– Considers opportunistic actions that could be taken once
various contractual arrangements have been put in place
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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
• Managers have access to information not available
to principals
• Methods of reducing agency costs of equity
– Price protection, monitoring by owners, bonding by
managers, managers may be rewarded
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Positive Accounting Theory (PAT) (cont.)
Bonus schemes
• Remuneration based on the output of the
accounting system
• Accounting-based remuneration structures and their
existence can be explained by PAT
• Bonus payments
• Rewards based on market price of shares
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Accounting performance
measures used in Australia
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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
Mechanisms that align the interests of managers and
owners
• Threat of takeovers to underperforming firms
• A well-informed labour market
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Positive Accounting Theory (PAT) (cont.)
Debt contracting
• Agency costs of debt
• Managers interests versus shareholders’ interest
• Ways to minimise the agency costs of debt
– Price protection
– Contracting
– Monitoring
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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
• Organisations are affected by governments, trade
unions, environmental lobby groups or particular
consumer groups
• Demands placed on the firm might be affected by
accounting results
• Accounting numbers might be used as a means of
providing ‘excuses’
• There will be a perception that highly profitable
organisations can ‘afford’ to pay
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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
The three main hypotheses of PAT are
– Bonus plan hypothesis
– Debt/equity hypothesis
– Political cost hypothesis
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PAT in summary
• Selection of accounting methods can be explained by either
efficiency or opportunistic arguments
• Such insights are important to use when we try to understand
why the managers of an organisation might have chosen one
accounting method in preference to another
• 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
• This theory provides insights into why managers might lobby
regulators in terms of the possible introduction of new
accounting practices—but we need to remember that the
whole theory is premised on ‘self-interest’
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Accounting policy selection and
disclosure
• AASB 101 Presentation of Financial Statements
comparison requirements
• PAT provides potential insights into why managers
might elect to select or change accounting policies
• Accounting policy choice and ‘creative accounting’
• Criticisms of PAT
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Normative accounting theories
• In contrast with positive theories (such as PAT),
normative theories:
– seek to provide guidance in selecting accounting
procedures that are most appropriate
– prescribe what should be done
• The Conceptual Framework is considered a
normative theory
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Normative accounting theories (cont.)
Other examples of normative theories:
•
Three normative theories advanced in the 1960s
which was a time of rising prices (inflation)
1. Current-cost accounting
2. Exit-price accounting
3. Deprival-value accounting
•
These theories addressed issues associated with
changing prices
•
Developed in 1950s and 1960s during a period of
high inflation
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Systems-oriented theories
• These theories focus on the role of information and
disclosure in the relationships between
organisations, the State (government), individuals
and groups
• The entity is assumed to be influenced by the
society in which it operates and also to have an
influence on it
• Systems-based theories include:
– Stakeholder Theory
– Legitimacy Theory
– Institutional Theory
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The organisation viewed as part of a
wider social system (Figure 3.1)
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Systems-oriented theories (cont.)
Stakeholder Theory
Two branches
1. Ethical (normative) branch
2. Managerial (positive) branch
1. Ethical (normative) branch
Stakeholders are any group or individual who can affect or
are affected by the achievement of the firm’s objectives
2. Managerial (positive) branch
Seeks to explain and predict how an organisation will react
to demands of various stakeholders
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Systems-oriented theories (cont.)
Legitimacy Theory
• Another ‘positive’ theory is 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
• Where this social contract is perceived as being
breached then the organisation will take corrective
action, and this action might include disclosure
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Systems-oriented theories (cont.)
Institutional Theory
• Explains why organisations within particular ‘fields’
tend to take on similar characteristics and form
• Much overlap with Legitimacy Theory and
Stakeholder Theory
• Two main dimensions to the theory—isomorphism
and decoupling
• Under this theory organisations adopt particular
practices—including disclosure practices—because
doing so provides legitimacy
• Particular practices might be adopted despite the fact
they are not necessarily the most efficient practices
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Theories explaining why
regulation is introduced
• Just as there are theories to explain why particular
accounting disclosures are made (e.g. PAT,
Legitimacy Theory, Stakeholder Theory), or why
particular organisational forms exist (Institutional
Theory), there are also theories to explain why
particular regulations (e.g. accounting regulations)
are developed. Such theories include:
– Public interest theory
– Capture theory
– Economic interest group theory
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Summary
• The lecture describes various theories that relate to
financial accounting
• No single accounting theory is universally accepted
• What theory we prefer to embrace will in part be
influenced by our own ‘world views’
• Positive Theory of Accounting
– seeks to explain and predict accounting-related phenomena
– e.g. study of capital market’s reaction to particular accounting
policies; what motivates managers to select a given method of
accounting; reasons for the existence of particular accountingbased contracts
– relies upon a fundamental assumption that individual action
can be predicted on the basis that all action is driven by a
desire to maximise wealth (a perspective often criticised by
other researchers)
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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 prescription—inform 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, Legitimacy Theory, and
Institutional 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 and particular organisational forms
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 pressures—how a firm operates and what it
reports will be influenced by various stakeholder
expectations
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Summary (cont.)
Theories that seek to explain how regulation is
developed
•
Some theories (public interest theory) 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’
theory—however, different theoretical perspectives can at
various times provide valuable insights in accounting issues
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