Power point slides- Positive Accounting Theory Part 1

DISCOVERERS WELCOME

  • Murdoch UNIVERSITY

  • Accounting Theory

  • Positive Accounting Theory (PAT) Part 1

Learning Objectives

  • 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

    • Describe, explain or predict activities

    • Help us understand what happens in the world

    • Example: Agency theory

Positive Accounting Theory

  • Used to explain and predict accounting practice.

  • Examines a range of relationships between:

    • 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 organization is characterized as a legal ‘nexus of contracts’.

  • Contracting parties have rights and responsibilities under these contracts.

  • Focuses on:

    • Managerial contracts

    • Debt contracts

  • These contracts help manage relationships where there is a separation between management and capital providers.

Agency Theory

  • Understands relationships where a principal employs an agent and delegates decision-making authority.

  • Creates a moral hazard.

  • Leads to three ‘costs’:

    • Monitoring costs: Cost of observing agent’s behavior (e.g. Auditing)

    • Bonding costs: Costs borne by the agent to align interests with the principal (e.g. preparing financial reports)

    • Residual loss: Loss associated with not fully aligning interests of principal and agent

Agency Relationships – Outcomes of Agency Theory

  • Agency Costs of Equity

    • Risk-Aversion: Limited incentive to increase firm value through risky investments

    • Dividend Retention: Reduced incentive to pay dividends or optimally leverage debt

    • Horizon Problem: Short-term focus on performance

    • Over-consumption of Perquisites

Agency Relationships – Manager-Shareholder Implication

  • Reducing agency costs of equity:

    • Bonuses tied to firm performance to motivate managers:

      • Bonuses can be in cash and/or shares/share options

      • Tied to accounting numbers (net income, sales) or share price (market-based performance measures)

Agency Relationships – Shareholder-Debtholder Dilemma

  • Agency costs of debt:

    • Excessive dividend payments: Reduces debtholder security

    • Asset substitution: Investing in higher risk projects, benefiting managers not debtholders

    • Under-investment: Lack of incentive to invest in positive NPV projects

    • Claim dilution: Issuing higher priority debt

Minimising Shareholder-Debtholder Dilemma

  • Reducing agency costs of debt:

    • Price Protection: Debtholders may increase interest charges or reduce loans

    • Align interests of shareholders and debtholders through lending restrictions (Loan Covenants)

    • Covenants rely on numbers in financial statements and usually restrict managers' behavior.

DISCOVERERS WELCOME

Murdoch UNIVERSITY

Accounting Theory

Positive Accounting Theory (PAT) Part 1

Learning Objectives

At the conclusion of this lecture, you should have an appreciation of the principal arguments of positive accounting theory, the links between accounting information and share markets, how contractual relationships impact managerial accounting policy choice, the ways principals curb opportunistic behavior by managers, the incentives that induce managers to contract, as well as institutional theory, legitimacy theory, and stakeholder theory.

Types Of Theories

There are two main categories of theories: Positive Theories and Positive Accounting Theory. Positive Theories describe, explain, or predict activities and help us understand what happens in the world, with agency theory as an example. Positive Accounting Theory, on the other hand, is used to explain and predict accounting practice by examining various relationships between entities and their suppliers of equity capital, managerial labor, and debt capital, all based on the assumption of the ‘rational economic person.’

Contracting Theory

Contracting Theory suggests that an organization is characterized as a legal ‘nexus of contracts,’ wherein contracting parties have rights and responsibilities defined by these contracts. This theory focuses on managerial contracts and debt contracts, helping to manage relationships where there is a separation between management and capital providers.

Agency Theory

Agency Theory helps us understand relationships where a principal employs an agent and delegates decision-making authority, which can create a moral hazard. This leads to three types of agency costs: monitoring costs, which are the costs of observing the agent’s behavior (like auditing); bonding costs, incurred by the agent to align interests with the principal (such as preparing financial reports); and residual loss, the loss associated with the misalignment of interests between the principal and agent.

Agency Relationships – Outcomes of Agency Theory

In terms of agency costs of equity, issues such as risk aversion limit incentives for managers to increase firm value through risky investments. There are also factors like dividend retention, which reduces the incentive to pay dividends or optimally leverage debt, and the horizon problem, which results in a short-term focus on performance that can lead to over-consumption of perquisites.

Agency Relationships – Manager-Shareholder Implication

To reduce agency costs of equity, bonuses tied to firm performance can motivate managers. These bonuses may be in cash or involve shares/share options and can be linked to accounting numbers (like net income and sales) or share price (using market-based performance measures).

Agency Relationships – Shareholder-Debtholder Dilemma

In the context of agency costs of debt, several issues arise such as excessive dividend payments that reduce debtholder security, asset substitution, wherein managers may invest in risky projects to benefit themselves rather than the debtholders, and under-investment, where there is a lack of incentive to pursue positive NPV projects. Claim dilution, from issuing higher priority debt, is another concern.

Minimising Shareholder-Debtholder Dilemma

To reduce agency costs of debt, debtholders may increase interest charges or reduce loans as a form of price protection. Additionally, aligning the interests of shareholders and debtholders is essential and can be accomplished through lending restrictions, or loan covenants, which typically rely on financial statement numbers and restrict managerial behavior.