Chapter 5 – Theories in accounting

Types of theories:

1. Normative (provide recommendations on what should happen)

2. Positive (describes, explains or predicts activities)

Positive theories

1. Contracting theory
a. Suggests organisations are characterised as a legal nexus of contracts (meaning there
are no implied contracts)
b. Narrows down management duties to only contracts
c. Creates issues such as how to evaluate employees, promotions, etc?
2. Agency theory
a. Used to understand principal-agent relationship
b. Principal – capital providers (investors, creditors)
c. Agent – management
d. The principal delegates the decision-making authority to the agent.
e. Both parties are assumed to be utility maximisers (always look for own happiness),
so agent will not always act in the best interest of the principal.
f. Must always assume that managers are economic men (maximize own wealth
regardless of anything else)
g. As a result, 3 agency costs are raised:
i. Monitoring costs
1. Incurred by principal to measure, observe and control the agent’s
behaviour
2. There is no trust between principal and agent
3. e.g. require audit of financial statements, place operating rules, or
costs to set up a management compensation plan
4. these costs are passed on to the agent (reduce compensation)
5. lenders can increase the rates charged on loans to pass on the
monitoring costs to the agent
6. decreasing renumeration (management compensation) or increasing
cost of borrowing is known as price protection
ii. Bonding costs
1. Incurred by management
2. Agents bear the monitoring costs to try to gain trust of the principal
3. Agent provide assurance that they are making decisions in the best
interest of the principal e.g. present performance reports (even if
this might reduce efficiency)
4. Agent may agree to link reports with renumeration payment,
creating incentive for agent to enhance entity performance.
5. These activities are called bonding costs
iii. Residual loss
1. Sometimes monitoring costs are higher than expected benefits
2. It is too costly to guarantee an agent will make decisions optimal to
the principal at all times and in all circumstances
3. Principal bears this cost known as residual loss
h. Owner-manager agency relationships
i. Horizon problem
 1. Managers and shareholders have differing time horizons in relation
to the entity (managers have short term vision, owners have long
term vision)
2. Shareholders want managers to make decisions that enhance the
future cash flows of the entity over the long term
3. Managers are interested in the cash flow potential as long as they
are expected to be employed by the entity
4. This problem mostly arises when managers are about to retire or
move to another entity (they don’t care about what will happen
after they leave)
5. Managers wanting to move, will place many efforts in short term
profitability to show effective management, and be able to
control/increase the renumeration of their new job
6. Short term profitability can be done by delaying maintenance or
upgrades to PPE, reducing research and developing expenses
7. These result in long term consequences
8. This problem is reduced by linking manager rewards to long term
performance of the entity
9. E.g. linking bonus to share price or using share options
ii. Risk aversion
1. Managers prefer less risk than shareholders
2. Managers look for diversification of investments
3. Managers are more invested in the company, since it is their primary
source of income, compared to the limited liability of the
shareholders, so they have more to lose
4. Shareholders prefer higher risk, because of higher returns
5. This can be solved by providing a compensation plan that
encourages managers to take high risk investments
iii. Dividend retention
1. Managers prefer to maintain more funds (cash) within the entity and
pay less of the entity’s earnings as dividends
2. Managers want to expand the size of the business that they control
by retaining the money (empire building) and pay their own salaries
and bonuses
3. Shareholders want to maximise their returns through increased
dividends
4. Also solved by renumeration plans
5. The compensation policy influences how top executives behave
i. Manager-lender agency relationships
i. Excessive dividend payments
1. Managers act on behalf of the owners
2. If managers issue high level/excessive dividend payments, this could
lead to a reduction of the asset base securing the debt, or leave
insufficient funds to pay the debt
3. To reduce the problem, covenants are made (debt requirements)
that restrain the dividend policy or restrict the dividend pay-out
(basically restricting cash)
4. These covenants are usually used with secured loans
ii. Underinvestment
 1. Managers do not accept positive NPV investments if they provide
more funds for the lenders to take (especially when there is financial
difficulty)
2. There is no motivation on improving the assets
3. This can be solved by covenants that restrict investment
opportunities of the entity (require stable investments to be made)
iii. Asset substitution
1. owners gain when managers invest in risky projects
2. lenders don’t, since they determine a fixed rate on the loan from the
beginning in accordance with the risk of the asset it is tied to
3. managers use the creditors’ loans to substitute investments with
high risk, no extra return is given to the creditors (managers take a
loan with a lower risk, so lower interest, and use this money to make
riskier investments with higher returns that go to the owners)
4. this can also be solved by restricting investment opportunities, or
securing the debt to a specific asset, or restricting debt to tangible
assets ratio
iv. Claim dilution
1. Manager take on a debt with higher priority than the others (must
pay the creditors with the higher priority first)
2. This can be solved by restricting borrowing of higher priority debt
(lenders place a debt covenant that states that the entity cannot
take another debt with a higher priority than theirs)
j. Role of accounting information in reducing agency problems
i. Accounting information plays two roles in reducing agency problems
1. The first is where the terms of managerial compensation or lending
agreements are written in terms of accounting information;
2. and the second is where accounting information is used to
determine performance against the terms of the contracts.
k. Information asymmetry
i. Results from managers having more information about the current and
future prospects of the entity than outsiders and can choose when and how
to disseminate (expose) this information
ii. Entities should always disclose information whether good or bad to avoid
adverse selection (when one entity does not disclose information while all
others are, it is assumed they have really bad news and the share price goes
down as a result) and to avoid being seen as a bad investment
3. Institutional theory
a. Used to understand the influences on organisational structures
b. Considers how rules, norms and routines become established as authoritative
guidelines
c. Considers how these elements are created, adopted and adapted over time
d. Practices within organizations can be predicted from perceptions of behavior from
cultural values, industry tradition, entity value etc.
e. Multinational corporations are likely to face differing institutional environments in
which they operate, and consequently need to adjust their operations accordingly
f. Corporations are more likely to act socially responsible if strong regulations were in
place or if they were being monitored
 g. Accounting disclosures are likely to be a way of demonstrating corporate legitimacy
by disclosing how the organization is meeting the expectations of these rules, norms
and guidelines.
4. Legitimacy theory
a. used to understand corporate action and activities, particularly relating to social and
environmental issues
b. company operates to be approved by society
c. based on social contract
i. relates to the implicit and explicit expectations society has on how the
business should act
ii. not a written agreement, it is an understanding of what society expects
iii. there are no regulations
d. Organisational legitimacy
i. used to explain the process by which the social contract is maintained
ii. organizations can only continue to exist if the society in which they operate
approve their actions
iii. organization must appear to consider the rights of the public at large, not
just its shareholders
iv. it is what the business is trying to do to fulfil the social contract
e. Accounting disclosures and legitimation
i. 4 ways an organisation can maintain their legitimacy:
1. Educate and inform society in changes of performance
2. Change perceptions of society
3. Manipulate perception by deflecting attention from issues and
problems
4. Change expectations of performance
ii. Public reporting through annual reports or website can be a powerful tool in
showing an organisation is meeting the expectations of society
5. Stakeholder theory
a. Similar to legitimacy theory
b. Stakeholder theory examines relationship between organisations and their
stakeholders, whereas legitimacy theory examines relationship between
organisations and society as a whole
c. Identifies stakeholders separately
d. Two branches of stakeholder theory
i. Normative branch – ethical/moral treatment of stakeholders; Stakeholders
have a face and name; should all be treated fairly; one shareholder is not
perceived as more important than another.
ii. Managerial branch – explains how stakeholders might influence
organisational actions; examines relationship with different stakeholder
groups within society; try to find a way to satisfy all stakeholder needs at the
same time
e. Role of accounting information in stakeholder theory
i. Similar to legitimacy theory
ii. Provide information about organisational activities and performance to meet
stakeholder’s needs
iii. Disclosure of voluntary information to stakeholders
6. Contingency theory
a. Organisations are all affected by a range of factors that differ across organisations
 b. Organisations need to adapt their structure to consider these factors (e.g. external
environment, business size and strategy, etc)
c. No one best way to organise, no universal appropriate accounting information
system or strategic management accounting system
d. Organisational effectiveness is achieved by matching organisational characteristics to
contingencies (e.g. technology, innovation, environmental change, etc)
e. Contingency frameworks are also used to evaluate management accounting
information systems and internal control systems

Using theories to understand accounting decisions

 Accountants are required to judgements to make decisions:

o Expense or capitalise costs?
 Need to make decisions on timing and nature of activities
 Expensing rather than capitalising reduces short term profits
 Agency theory explains that managers whose bonuses are tied to the current
entity performance would rather capitalise
 If compensation is ties to long term performance, managers would expense
o Which accounting estimate to use
 Agency contracts explain managerial decisions
 Managers acting in self-interest ensure own bonuses are being maximised
and no debt covenants are being breached
o Recognise information within the statements or in the notes?
o Disclose additional information?
 Stakeholder theory explains that disclosures are to maintain good relations
with powerful stakeholders
 Legitimacy theory explains that disclosures are to fulfil the social contract
 Institutional and contingency theories explain disclosures are to meet
expectations of norms and external environment