GODFREY

HODGSON
HOLMES
TARCA

CHAPTER 11
POSITIVE THEORY OF ACCOUNTING
POLICY AND DISCLOSURE
Early demand for theory
• 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

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Early demand for theory
• Positive theory incorporated a 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

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Contracting theory
• The firm is 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)

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Agency theory
• An agency contract 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

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Agency theory
• The agency problem in turn gives rise to
agency costs spent to overcome it
– monitoring costs
– bonding costs
– residual loss

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 Agency Theory

Jensen and Meckling provide a definition

of agency costs that divides these costs
into their individual components:

Agency Monitoring Bonding Residual

Costs = Costs + Costs Loss
+
Out-of- Opportuni
Pocket ty
Costs Costs
Agency theory
• Monitoring Costs – 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…

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Agency theory
• The agents incur bonding costs in order to
reduce the monitoring costs they eventually
bear
• Agents stop spending on bonding costs when
the marginal cost equals the marginal
reduction in the monitoring costs they bear
– $1 = $1

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Agency theory
• 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

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Agency theory
• In the real world, 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
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Agency theory
• Agency theory attributes a role for accounting
• Accounting is part of the monitoring and
bonding mechanisms
• Accounting numbers are used in contracts

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 The Nexus of
Contracts
Theory of the Firm
Share-
Lessors holders Board of
Lessees Directors

Suppliers Fir Managers

m

Customers Employees
Bond-
holders

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 The Nexus of
Contracts
Theory of the Firm
Share-
Lessors holders Board of
Lessees Directors

Suppliers Fir Managers

m

Customers Employees
Bond-
holders

14
 Price protection and
shareholder/manager agency problems
• 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

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 Price protection and
shareholder/manager agency problems

• Risk aversion
– managers prefer less risk than do shareholders
• different degrees of diversification affecting risk
• limited liability accorded to shareholders

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 Price protection and
shareholder/manager agency problems
• Dividend-retention
– managers prefer to pay out less of the profits as
dividends than shareholders prefer
• pay their remuneration
• empire building

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 Price protection and
shareholder/manager agency problems
• Horizon
– managers have a shorter 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

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 Price protection and
shareholder/manager agency problems
• Contracting can be used 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

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Shareholder-debtholder agency
problems
• In this context, 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

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Shareholder-debtholder agency
problems
• Firm value is the 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)

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Shareholder-debtholder agency
problems
• Varieties of opportunistic behaviour
– excessive dividend payments
– asset substitution
– underinvestment
– claim dilution

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Shareholder-debtholder agency
problems
• 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

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Shareholder-debtholder agency
problems
• Asset substitution
– firm invests in higher risk projects to benefit
shareholders
• no benefit to debtholders
• but do share in possible losses
– shareholders are able to diversify and have limited
liability
– debt becomes mispriced

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Shareholder-debtholder agency
problems
• Underinvestment
– in some circumstances, 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

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Shareholder-debtholder agency
problems
• Claim dilution
– occurs when the firm issues debt of a higher
priority than the debt already on issue
– decreases the relative security and value of the
existing debt

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Shareholder-debtholder agency
problems
• Lenders will price protect
– 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

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Ex post opportunism versus ex
ante efficient contracting
Ex post opportunism
– occurs when, once a contact is in place, agents
take actions that transfer wealth from principals
to themselves

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Ex post opportunism versus ex
ante efficient contracting
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

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Signalling theory
• Managers voluntarily provide 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

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Political processes

• Often firms try 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

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 Conservatism, accounting
standards and agency 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

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Additional empirical tests of the
theory
• Testing the opportunistic and political cost
hypothesis
• Tests using contract details
• Refining the specification of political costs
• Testing the efficient contracting hypothesis

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Additional empirical tests of the
theory
• Evidence that managers use 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

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Evaluating the theory
• Mixed support 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

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Issues for auditors
• The demand for auditing can be explained by
agency theory as part of the monitoring and
bonding activity and costs
– higher quality auditors
– industry specialist auditors

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Summary
• Positive accounting theory has been a major force in
academic accounting research
• Incorporates a theoretical model of contractual
exchange between persons who use accounting
numbers to effect their payoffs
• Provides an explanation as to why accountants
account as they do
– minimises the cost of agency relationships
– yet opportunistic behaviour by agents is the norm
– but some efficient ex ante behaviour by agents

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Key terms and concepts
• Positive theory
• Contracting theory
• Agency theory
• Agents
• Principals
• Monitoring costs
• Bonding costs
• Residual loss
• Ex post settling up
• Risk aversion problem
• Dividend retention problem
• Horizon problem

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Key terms and concepts
• Shareholder/manager agency problem
• Shareholder/debtholder agency problem
• Excessive dividend payment problem
• Asset substitution problem
• Underinvestment problem
• Claim dilution problem
• Ex post opportunism
• Ex ante efficient contracting
• Signalling theory
• Political processes
• Conservatism

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