Positive theory of accounting policy and disclosure Contracting theory Contacting theory characteristic the firm as a legal nexus

(connection) of contractual relationship among suppliers and consumers of factors of production. The firm exist because it costs less for individuals to transact( or contract) through a central organization than to do so individually. In a more general sense, rather than all individual suppliers of the factors of production (land, labor and capital) individually contracting with consumers for heir output, contracts are struck by the the firm between classes of suppliers and consumers of factors. There are, for example, contracts: documenting the terms and conditions of employment of managers by shareholders documenting the terms and conditions under which lenders provide financial resources of employment for factory and other workers for the supply of goods for the sale and delivery of goods and services. Thus, one we allow for the reality of contract transactions costs, including financial and non financial costs of negotiating the terms of the sale of milk from a dairy farmer, Coase argues that firms will exist. The reason is that firms are the most efficient form of contract nexus in organizing and coordinating economic activity and reducing contracting costs. Although it is important to recognize that firms involve a multiplicity of contracts, positive accounting theory usually focuses on two types of contract: management contracts and debt contracts. Both of these contracts are agency contracts and agency theory provides a rich source of explanation for existing accounting practice. Agency theory In such a situation, both the principal and the agent are utility maximize and there is no reason to believe that the agent will always act in the principals best interests. The agency problem that arises is the problem of inducing an agent to behave as if he or she were maximizing the principals welfare. For example, where the agent is the firm manager, the manager has incentives to increase consumption of perquisites such as the use of a company car, expense account, or the size of bonus payments at the expense of the principal. Alternatively, the manager (agent) may seek to avoid personal stress from overwork and not

be as conscientious as possible in endeavors as possible in endeavors to maximize the firms value. Because the agent has decision making authority. He or she can transfer wealth in this manner from the principal to the agent if the principal does not intervene. This agency problem, in turn, gives rise to agency costs. At the most general level, agency costs are the dollar equivalent of the reduction in welfare experienced by the principal owing to the divergence of the principals and the agents interests. Jensen and Meckling divide agency costs into: monitoring cost bonding cost residual costs The appeal of agency theory lies in the fact that it attributes a role for accounting a s part of the bonding and monitoring mechanisms which is closely related to the traditional stewardship role of accounting. Our attention is now directed to specific agency relationship, particularly those which have been considered routinely by positive accounting theory. Reference is also made to the use of accounting numbers in the contracts between the contracting parties.

Price protection and shareholder/ manager agency problems The separation of ownership and control means that managers as the agents of shareholders, can act in their own interests but agents interest may be contrary to the interest of the shareholders. Partial ownership or non ownership of a firm by management provides incentives for managers to behave in a manner contrary to the interests of shareholders because management does not bear the full cost of any dysfunctional behavior. Reason for differences in shareholders and managers incentives regarding firm policies represent a number of specific problems. These problems include the risk aversion problem, the dividend retention problem and the horizon problem. The risk aversion problem means that managers prefer less risk than do shareholders. Shareholders have the capacity to diversify their investment portfolios so that they are not risk averse with respect to their investment in any particular firm. By investing in a variety of firms or types of investments, shareholders can minimize their exposure to investment risk from any one source. Diversifying their investments in this manner tends to hedge their exposure to risk of loss

from their investments. Shareholders risk aversion is further reduced by the fact that limited liability means that they have no obligation to cover future decrease in firm value except to the extent that their shares are not fully paid. Since their claim against the firm is essentially an option against the future value of the firm, their interest are best served if management invests in certain risky projects in order to maximize the value of the business. Shareholder-debt holder agency problems Smith and Warner recognized that the agency problem of debt can give rise to four main methods of transferring wealth from debt holders to shareholders: excessive dividend payments asset substitution underinvestment claim dilution The excessive dividend payment problem arises when debt is lent to a firm on the assumption of a certain level of dividend payout. Debt is priced accordingly, but the firm then issues a higher level of dividends. Issuing higher dividends reduces the asset base securing the debt and reduces the value of the debt. Asset substitution is based on the premise that lenders are risk averse. They lend to a firm with the expectation that it will not invest in asset or projects of a higher risk than that which is acceptable to them. They price debt accordingly, via the rate of interest charged or the term of the loan. After all, they do not share in the increased returns that high-risk projects can provide. However, they do share in the possible looses to the extent that the looses reduce the security available to meet their claims. Underinvestment occurs when owners have incentives not to undertake positive NPV project because to do so would increase the funds available to the debt holder but not to the owners. Claim dilution occurs when the firm issues debt of a higher priority than the debt already on issue. This increases the funds available to increase the value of the firm and the value of the ownership interest, but it decreases the relative security and value of the existing debt.

Ex post opportunism versus ex ante efficient contracting Ex post opportunism occurs when, once a contract is in place, agents take actions that transfer wealth from principals to themselves. In contrast, efficient contracting occurs when agents take actions that maximize the amount of wealth available to distribute between principals and agents and the information perspective simply argues that managers provide information to existing and potential investors with the intention of providing the best information possible to help decision making. Signaling theory relates to each perspective by predicting that managers will provide information that forms the basis for expectations reflected in contractual terms or investment decisions.

Signaling theory The information hypothesis is aligned with signaling theory, whereby managers use the accounts to signal expectations and intentions regarding the future. According to signaling theory, if managers expected a high level of future growth by the firm, they would try to signal that to investors via the accounts. Managers of other companies that are performing well would have the same incentive and managers of firms with neutral news would have incentives to report positive news so that they were not suspected of having poor results. Managers of firms with bad news would have incentives to report their bad news, to maintain credibility in effective markets where their shares are traded. Assuming these incentives to signal information to capital markets, signaling theory predicts that firms will disclose more information than is demanded. The logical consequence of signaling theory is that there are incentives for all managers to signal expectations of future profits because, if investors believe the signals, share prices will increase and the shareholders will benefit. Political processes Positive accounting theory also models the political process involving the relationship between the firm and other parties interested in the firm, such as government, trade unions and community groups. As in the context of debt and management compensation contracting, accounting is important in the political process as one of the sources of information about firms.

The major difference between the political market and the capital market is that there is generally less demand and therefore less incentive for the production of information in political markets. Economic analysis suggests that this results from the lower marginal benefit to individuals in the political process, because it is harder for individuals or groups to capture benefits from that information. There are high information costs to individuals, heterogeneity (diversity) of interest and organizational costs. Conservatism, accounting standards and agency costs Conservatism arises because there is an asymmetric verification requirement that imposes a higher degree of verification for revenues when compared to expenses and this generally serves to reduce reported earnings. Further, the valuation system was based on historical costs and revaluations were not allowed in the United states. Moreover, the use of conservative historical costs effectively means that any increased asset values will leak into earnings as they are realized through transactions rather than through the immediate jump in value. This was a reaction against some aggressive accounting methods used in the 1920s. Additional empirical tests of the theory Empirical tests provide evidence that managers use accounting numbers to counter political pressure to gain political advantages such as export credits to set targets for managers that have upper and lower compensations limits, to reduce debt covenants, to provide dividend constraints and to generally play a significant role in constraining management manipulation. Evaluating the theory Positive accounting theories have been criticized on the grounds of their usefulness, their methodological and statistical rigor and their philosophy. In response, positive accounting researches argue they develop a theory that has an information role that is managers, auditors, lenders and others demand theories that help them to predict the effects of accounting choices on their welfare and in setting up efficient contracts. Moreover, through its contribution to explanation and prediction, positive theory helps parties such as standard setters to understand the consequence of their actions in removing the conservative bias of accounting practices. Issues for auditors

Auditors have a bonding and monitoring role in agency theory. Auditing is now a legal requirement but there is evidence that auditing was voluntarily undertaken in the past. Researches has also shown that higher quality auditors are demanded in situations where clients wish to signal that their accounts are of higher quality or where there are severe agency conflicts or weak control mechanisms. Industry specialist auditors are able to demand higher audit fees and clients demand research and development contract specialist auditors when firms have highly discretionary expenditures on research and development growth options.