accounting theory revision

2013/2014

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 2-hours

 Answer two questions

 9 topics

 75% weighting

 Date: Wed., 15th January 15.00-17.00 PG Hall

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1) Introduction to accounting theories

2) Regulatory theories

3) Normative theories: Asset valuation

4) PAT

5) Corporate governance theories

6) Systems-oriented theories

7) CSR theories

8) Capital market theories

9) Behavioural theories

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Descriptive theories Prescriptive (normative)

theories

Predictive (positive)

theories

Descriptive “what is” Prescriptive

“what should be”

Explanatory, predictive

“why it is” “what will

happen”

Non-value laden Value-laden Non-value laden*

No empirical methodology No empirical methodology Empirically based

* PAT Assumes specific human characteristics

Asset valuation

theories, ethical branch of stakeholder

theory

PAT, legitimacy theory,

managerial branch of

stakeholder theory, etc.

 They analyse the behaviour of regulators, preparers & users of accounting information ◦ Regulators:

 Regulatory theories

◦ Preparers:

 PAT

 Systems-oriented theories

◦ Users:

 Positive Acc. Theory (Cap. Markets)

 Behavioural theories

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Regulatory theories

Normative

theories

Positive theories

Should

accounting be regulated?

Who should

be the regulator?

What

should the accounting

standards

be like?

How does the regulatory process work?

Public

interest

theory

Capture

theory

Institutional

theory

 Pro- regulation

vs.

 Free market

 Public or

private

sector

 e.g. IAS,

IFRS

Private

interest

theory/

Economic

interest

group

theory

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Advantages Disadvantages

Everybody has access to the same amount

of info  ensures public confidence

Restricts accounting choice: firms cannot

choose accounting treatment that best

reflects underlying transaction

lack of regulation causes underproduction

of information (true demand is

understated)

Market provides penalties for non-supply

of info

Competition does not guarantee optimal

supply of info  Firms are monopolist

suppliers of info about themselves 

Markets assumes o info is bad news

(lemons)

protects the more vulnerable Litigation costs prevent misleading info

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Cost

Value

Historic

cost

Current cost

(entry price)

Value in

use

Value in exchange

(exit price)

Acquisition

cost

Current

purchasing

power cost

Replacement

cost

Current

cost

Present

value

Fair

value

Net

realisable

value

Less

depreciation

Historic

cost

adjusted

by a price

index

Cost of

same item in

same

condition

Cost of

item

performing

same

services

Present

discounted

value of

future net

cash flows

Market

value

Market

value

less cost

of sale

9

historical cost current purchasing power current cost exit price

 Reliability

 Objectivity

 Easily understood

by users

 Relevance (sunk costs)

 Subjectivity

 Exclusions (goodwill)

 Problems with

additivity

 Capital erosion

 What about revaluations

?

 Numbers can be

added

 Data readily

available

 Hard to understand

 What about physical

capital

maintenance

 Maintenance of physical

capital

 Complicated calculations

 Replacement cost not the

same for all

firms

 Replacement cost ≠ exit

price

 Reliability (market prices)

 Relevance (market

participants)

 Understandability & comparability

 Firm is going

concern

 Does not intend to

sell assets

separately

 Subjectivity if no market

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Agency theory

Positive Accounting

Theory (PAT)

Corporate governance

theories

• Separation of ownership and

control • Management – owners

(shareholders) • Management - debt holders

(lenders) • Moral hazard • Information asymmetry

Role of accounting in contracting process: (a) monitoring (b) bonding

Role of accounting in corporate governance mechanism

Accounting policy choice

• Directing and

controlling managerial behaviour

• Disclosure

Managerial self-interest:

Reporting bias

 Corporate governance is “the system by which business corporations are directed and controlled” (Cadbury, cited in Cowan, 2004, p. 15.).

 The corporate governance structure specifies the distribution of rights and responsibilities among the different participants in the organisation (e.g., the board, managers, shareholders and other stakeholders) and lays down the rules and procedures for decision-making

 By doing this, it also provides the structure through which the company objectives are set, and the means of attaining those objectives and monitoring performance

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 Agency theory views the firm as a nexus (network) of contracts

 These contracts determine the relationships with and among the various parties involved

 A key relationship is the agency contract  An agency relationship by definition has two key

parties: 1. A principal (shareholders) who delegates the authority

to make decisions to the other party 2. An agent (managers) who is the person given the

authority to make decisions on behalf of the principal.

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 The agent has a duty to act in the interests of the principals ◦ However, there is a common assumption in economic theory

which is, if individuals are rational, they will act in their own best interests and this can lead to the agent making decisions to maximise their own wealth, rather than the principals

 Principals are also rational and will expect that the managers will not always act in the shareholders’ interests

 This leads to three costs associated with this agency relationship:

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1. Monitoring costs ◦ These are costs incurred by principles to measure,

observe and control the agent’s behaviour

2. Bonding costs ◦ These are restrictions placed on an agent’s actions

deriving from linking the agent’s interest to that of the principal

3. Residual loss ◦ This is the reduction in wealth of principals caused by

their agent’s non-optimal behaviour

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 Positive theory: explain and predict managerial discretionary choices: ◦ Accounting method choice ◦ Disclosure choices (including CSR reporting)

 Based on economic theories 1. Agency theory

 Conf lict of interest & information asymmetries between managers and investors

2. Rational choice theory  Managers are rational (weigh up costs and benefits of

decisions)

 Managers are self-interested

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 Based on aggregate theory of the firm ◦ Firm = nexus of contracts between individuals

 Opportunistic perspective: 3 hypotheses: ◦ Bonus plan hypothesis ◦ Debt hypothesis ◦ Political cost hypothesis  can also be used in the context

of CSR reporting

 Based on ‘scientific’ research ◦ Large samples, statistics, hypothesis testing; aim =

universal truth claims

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 Provide alternative to Positive Accounting Theory  They originate in sociology  They regard the organisation as a part of the broader

social system ◦ Economic, social and political aspects are intertwined

◦ Address relationship of firms with all stakeholders and society (rather than just shareholders and debtholders)

 Analysis takes social context into account  Provide explanations of why firms choose specific

accounting methods and provide voluntary disclosures  In order to demonstrate that organisational practices are

aligned with social norms and rules

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1. Legitimacy theory ◦ Relationship between the firm and society

◦ Definition of legitimacy:

 Is the status or condition which exists when an entity’s value system is congruent with that of society

◦ Based on notion of social contract

◦ Focuses on social rules and norms

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2. Stakeholder theory ◦ Relationship between firms and its

stakeholder groups

◦ Definition of stakeholders:  “Any identifiable group or individual who can affect the

achievement of an organisation’s objectives, or is affected by the achievement of an organisation’s objectives” (Freeman and Reed, 1983)

◦ Differentiates between primary & secondary stakeholders

◦ Focuses on stakeholder demands and expectations

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3. Institutional theory ◦ Explains how legitimacy mechanisms become

institutionalised ◦ Two elements to Institutional Theory  Isomorphism  Decoupling

◦ Coercive Isomorphism  Responding to stakeholder pressure

◦ Mimetic Isomorphism  Copying other organisations

◦ Normative Isomorphism  Responding to group norms and values

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Why do firms

provide

environmental &

social

disclosures?

to conform to

norms and

values of society

to satisfy

information

needs to firm

outsiders

to emulate

practices of

other firms

legitimacy

theory

stakeholder

theory

institutional

theory

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Focus: Self-interested utility

maximisation; rewards and

sanctions

Economic theories:

Agency theory

PAT

Organisation

Organisational

context

Focus: Social norms and rules

Systems-oriented theories:

Legitimacy theory, stakeholder

theory, institutional theory

Rational action

Non-rational action

c o n

tin u

u m

continuum

 Garriga & Melé (2004):

1) Positive theories  Instrumental theories  PAT

 Political theories

 Integrative theories  systems-oriented theories

2) Ethical (normative theories)  Ethical branch of stakeholder theory

 See overview in Garriga & Melé (2004: 63-63), Table 1.

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Explain why firms engage in CSR activities & reporting

Explain why firms should

engage in CSR activities & reporting

 Positive theory: explain and predict the behaviour of users of accounting information ◦ Reactions of investors to accounting information

◦ Association between accounting numbers and share prices

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 Based on economic theories ◦ Rational choice theory  Investors are rational (weigh up costs and benefits of

decisions)

 Investors are self-interested

 Based on semi-strong form of market efficiency ◦ Share prices ref lect all publicly available information

 Based on CAPM ◦ Separates total returns into normal (market) and

abnormal (firm-specific) returns

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 Based on ‘scientific’ research ◦ Large samples, statistics, hypothesis testing; aim

= universal truth claims ◦ Share price movements used as a proxy of

investor reactions ◦ Association between accounting information

(earrings) and share prices

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 Positive theory: explain and predict the behaviour of preparers and users of accounting information ◦ We focus specifically on users

 Analysis of behaviour of specific user groups ◦ e.g. financial analysts, land officers, or unsophisticated

investors

 Based on psychology theories  Methodology ◦ Experiments ◦ Verbal protocol analysis ◦ Participant observation

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 Assumptions about human behaviour ◦ Investors are not rational – bounded rationality

◦ Use of heuristics (rule of thumb)

◦ Investors suffer from various biases

◦ Markets are weakly efficient, inefficient

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Capital markets research

Event 1 Event 2

Release of new

info →

Decision-

making by users

of info

Share price

movement

Behavioural research

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Capital market research Behavioural research

Positive research: explain and predict human behaviour in

relation to the use of accounting information

Research question How do securities markets react

to accounting information?

How do people use and

process accounting

information?

Aim Examine relationship between

accounting information and

share prices

 Modelling of decision- processes

 Uncovering of cognitive and social

biases

Disciplines economics & finance psychology

Focus decision-making at aggregate

level

decision-making at

individual/group level

theories  Expected utility theory

 Rational choice theory

 Prospect theory

 Belief-adjustment model

 Functional fixation hypothesis

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Assumptions (Olsen

(1998)

‘homo economicus’:

 omniscient decision maker

 rationality

 Utility maximization – optimal solutions

 Solutions found by applying mathematical models

‘homo heuristics’:

 Bounded rationality, i.e. using rules of

thumb

 Satisfactory, rather than optimal solutions

 Cognitive, affective, and social biases

Market efficiency semi-strong form market inefficiency

Methodology  Event study: statistical models estimating abnormal

(unexpected returns) 

proxy for firm-specific news

 Association study: regression analysis

 Brunswick-lens model

 Verbal protocol analysis

 Experiments

Examples  Impact of earnings announcements on share

prices (Ball & Brown 1968)

 Analysts’ reactions to warnings of negative

earnings surprises

(Libby & Tan 1999)

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