Accounting theory & Accountability essay on stock exchange
Accounting Theory
Positive Accounting Theory (PAT) Part 1
1
The 5 key Learning Objectives in this lecture about PAT
At the conclusion of this lecture, you should have an appreciation of:
The principal arguments of a positive accounting theory
Links between accounting information and share markets
How contractual relationships impact on managerial accounting policy choice
How principals curb opportunistic behaviour by managers
The incentives that induce managers to contract
Institutional theory
Legitimacy theory and
Stakeholder theory
Types Of Theories
Positive Theories
Describes, explains or predicts activities
Help us understand what happens in the world
E.g. Agency theory
Positive Accounting Theory
Used to explain and predict accounting practice.
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
Contracting Theory
Suggests that the organisation is characterised as a legal ‘nexus of contracts’.
With contracting parties having rights and responsibilities under these contracts.
Positive accounting theory focuses on
managerial contracts, and
debt contracts,
These are agency contracts used to manage relationships where there is a separation between management and capital providers.
Agency Theory
Used to understand relationships whereby a principal employs the services of, and delegates the decision making authority to, an agent.
Creates a moral hazard.
Leads to 3 ‘costs’
Monitoring costs - the cost of observing the agent’s behaviour (e.g. Auditing)
Bonding costs - costs borne by the agent as a result of aligning their interests with the principal (e.g. manager has to prepare financial reports - a cost to the manager in terms of time and effort)
Residual loss - loss associated with not being able to fully align the interests of the principal with the agent
Agency Relationships – an outcome (adverse?) of Agency Theory
Agency Costs of Equity
Risk-Aversion – limited incentive to increase value of firm through investment in risky projects
Dividend Retention – reduced incentive to pay dividends or take on optimal levels of debt
Horizon Problem – short term focus on performance of firm
Over-consumption of Perquisites
Agency Relationships – the manager-shareholder implication
Reducing the agency costs of equity
Bonuses are usually tied to firm performance in some way to motivate managers to act in the owners’ interest
Bonuses can be paid in cash and/or shares/share options
Bonuses can be tied to:
Accounting numbers(such as net income, sales, return on assets)
Share price (market based performance measure)
Agency Relationships – the Shareholder-Debtholder dilemma
Agency costs of debt
Excessive dividend payments - reducing debtholder’s security
Asset substitution - firm invests in higher risk projects (no benefit to debtholder)
Under investment - where no incentive to invest in positive NPV projects
Claim dilution - issuing higher priority debt
Agency Relationships – minimising the Shareholder-Debtholder dilemma
Reducing the agency costs of debt
Debt-holders can Price Protect via increased interest charges or reduced amounts of loans provided
The interests of shareholders can be bonded to those of debtholders via restrictions in lending agreements (Loan Covenants)
Covenants often rely on numbers contained in financial statements
Covenants usually restrict the behaviour of managers acting on behalf of owners
The End