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Positive theory of accounting - policy and disclosure
Positive accounting theory sees the firm as a nexus of contracts between shareholders, managers, and debtholders. Agency theory and contracting theory explain how accounting is used to reduce agency costs that arise from the conflicts of interests between these parties. Accounting numbers are incorporated into contracts to monitor managers' behavior and align their interests with shareholders. However, empirical evidence for positive accounting theory has been mixed and inconclusive. It has also been criticized for focusing more on human behavior rather than the measurement of accounting entities.
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Positive theory of accounting - policy and disclosure
- 1. LECTURE 11 POSITIVE THEORYOF ACCOUNTING POLICY AND DISCLOSURE ARTHIK DAVIANTI, SE. MSI. AK. CA.
- 2. POSITIVE THEORY OF ACCOUNTINGPOLICY AND DISCLOSURE
- 3. EARLY DEMAND FORTHEORY Capital markets research tried to explain the effects of accounting was ultimately inconclusive and inconsistent mechanistic and no-effects hypotheses This research relied upon the EMH ultimately there were too many departures Led to the development of a positive theory of accounting policy choice 3
- 4. Positive theory incorporateda number of observations many firms voluntarily provided accounting reports firms lobbied in relation to accounting standards firms made consistent policy choices firms tended toward conservatism 4 EARLY DEMAND FOR THEORY
- 5. CONTRACTING THEORY The firmis seen as a ‘nexus’ of contractual relationships The firm is seen as an efficient way of organising economic activity to reduce contracting costs equity (management) contracts (an agency contract) debt contracts (an agency contract) 5
- 6. AGENCY THEORY An agencycontract is one where one party (the principal) engages another (the agent) to act on their behalf e.g. where there is a separation of management and ownership Both parties are utility maximisers agent may therefore act from self-interest divergence of interests is the agency problem contracts incorporating accounting numbers can be used to align the interests of both parties 6
- 7. AGENCY THEORY The agencyproblem in turn gives rise to agency costs spent to overcome it monitoring costs bonding costs residual loss 7
- 8. AGENCY THEORY • MonitoringCosts – the cost of monitoring the agent’s behaviour; initially borne by the principal but passed on to the agent through an adjustment to their remuneration (price protection) auditing costs, operating rules… • Bonding Costs – the cost borne by the agent as a result of them taking action to align their interests with those of the principal providing more regular financial reports (a cost to the manager in terms of time and effort) constraints on their activities… 8
- 9. Residual Loss –the loss associated with not being able to fully align the interests of the agent with those of the principal Ex post settling up – (ex post = at the end of each period) agent’s future remuneration based on observed agent performance the principal changes the remuneration to be paid to the agent to align it with their performance 9 AGENCY THEORY
- 10. In the realworld, price protection and settling up are not perfect or complete Agents perceive that they will therefore not be fully penalised for their divergent behaviour They have incentives to act opportunistically This increases the residual loss This loss is borne by the principal as well as, or instead of, the agent 10 AGENCY THEORY
- 11. Agency theory attributesa role for accounting Accounting is part of the monitoring and bonding mechanisms Accounting numbers are used in contracts 11 AGENCY THEORY
- 12. PRICE PROTECTION AND SHAREHOLDER/MANAGER AGENCYPROBLEMS The separation of ownership and management leads to divergent behaviour by agents Divergence comes about because of the risk-aversion problem the dividend-retention problem the horizon problem 12
- 13. Risk aversion managers preferless risk than do shareholders different degrees of diversification affecting risk limited liability accorded to shareholders 13 PRICE PROTECTION AND SHAREHOLDER/MANAGER AGENCY PROBLEMS
- 14. Dividend-retention managers prefer topay out less of the profits as dividends than shareholders prefer pay their remuneration empire building 14 PRICE PROTECTION AND SHAREHOLDER/MANAGER AGENCY PROBLEMS
- 15. Horizon managers have ashorter time horizon with respect to their association with the firm than do shareholders shareholders are interested in future cash flows managers have a time horizon only as long as they intend to remain with the firm 15 PRICE PROTECTION AND SHAREHOLDER/MANAGER AGENCY PROBLEMS
- 16. Contracting can beused to reduce the severity of these problems manager remuneration is usually tied to firm performance in some way to motivate managers to act in the shareholders’ interest performance can be related to accounting numbers such as sales, profits, return on assets, net asset growth, cash flow, etc performance can be related to the firm’s share price 16 PRICE PROTECTION AND SHAREHOLDER/MANAGER AGENCY PROBLEMS
- 17. SHAREHOLDER-DEBTHOLDER AGENCY PROBLEMS In thiscontext, the manager is assumed to be either the sole owner of the firm, or has interests that are totally aligned with the interests of the shareholders the principal is the debtholder the agent is the manager acting on behalf of shareholders 17
- 18. Firm value isthe value of debt plus the value of equity The value of equity can be increased by either increasing the value of the firm (efficient contracting); or transferring wealth away from debtholders (opportunistic behaviour) 18 SHAREHOLDER-DEBTHOLDER AGENCY PROBLEMS
- 19. Varieties of opportunisticbehaviour excessive dividend payments asset substitution underinvestment claim dilution 19 SHAREHOLDER-DEBTHOLDER AGENCY PROBLEMS
- 20. Excessive dividend payments reduces the asset base securing the debt shareholders have received cash but limited liability protects them from being personally liable for the debts of the firm in the event of bankruptcy the debt becomes mispriced reduces the value of the debt 20 SHAREHOLDER-DEBTHOLDER AGENCY PROBLEMS
- 21. Asset substitution: 1. firminvests in higher risk projects to benefit shareholders no benefit to debtholders but do share in possible losses 2. shareholders are able to diversify and have limited liability 3. debt becomes mispriced 21 SHAREHOLDER-DEBTHOLDER AGENCY PROBLEMS
- 22. Underinvestment in somecircumstances, shareholders have incentives not to undertake positive NPV projects because to do so would increase the funds available to the debtholders but not to the shareholders 22 SHAREHOLDER-DEBTHOLDER AGENCY PROBLEMS
- 23. Claim dilution occurswhen the firm issues debt of a higher priority than the debt already on issue decreases the relative security and value of the existing debt 23 SHAREHOLDER-DEBTHOLDER AGENCY PROBLEMS
- 24. Lenders will priceprotect through interest rates, the withholding of funds and the length of the loan The interests of shareholders can be bonded to those of debtholders via restrictions in lending agreements loan covenants 24 SHAREHOLDER-DEBTHOLDER AGENCY PROBLEMS
- 25. EX POST OPPORTUNISM VERSUSEX ANTE EFFICIENT CONTRACTING Ex post opportunism occurs when, once a contact is in place, agents take actions that transfer wealth from principals to themselves Ex ante efficient contracting occurs when agents take actions that maximise the amount of wealth available to distribute between principals and agents ex ante – before contracts are finalised 25
- 26. SIGNALLING THEORY Managers voluntarilyprovide information to investors - signals - to assist in their decision making Similar to efficient contracting Aligned with the information hypothesis Managers signal expectations and intentions regarding the future Incentives to signal good, neutral and bad news 26
- 27. POLITICAL PROCESSES Often firmstry to avoid public attention that is costly to them financially in terms of public perception and reputation They reduce their reported profit or its volatility e.g. banking sector in Australia 27
- 28. CONSERVATISM, ACCOUNTING STANDARDS ANDAGENCY COSTS Conservatism shows a bias by accountants accelerating recognition of expenses and decelerating recognition of revenue IASB argues this does not reveal the real financial picture and reduces information available to users 28
- 29. ADDITIONAL EMPIRICAL TESTS OFTHE THEORY Testing the opportunistic and political cost hypothesis Tests using contract details Refining the specification of political costs Testing the efficient contracting hypothesis 29
- 30. Evidence that managersuse accounting numbers to counter political pressure gain political advantages set management targets related to remuneration minimise breaching debt covenants provide dividend constraints constrain management manipulation 30 ADDITIONAL EMPIRICAL TESTS OF THE THEORY
- 31. EVALUATING THE THEORY Mixedsupport for positive accounting theory Two categories of major criticism methodological and statistical criticism empirical evidence is weak and inconclusive philosophical criticism contrary to its claims, it is laden with value judgments focuses on human behaviour and not the behaviour and measurement of accounting entities positivism is no longer taken seriously 31
- 32. ISSUES FOR AUDITORS Thedemand for auditing can be explained by agency theory as part of the monitoring and bonding activity and costs higher quality auditors industry specialist auditors 32
- 33. SOURCE: GODFREY, HODGSON, HOLMES,AND TARCA (2012) ACCOUNTING THEORY 7TH EDITION IAI (2015) STANDAR AKUNTANSI KEUANGAN PER EFEKTIV 1 JANUARI 2015