Theories in Accounting Practice: Understanding Agency Contracts and Disclosure

1. ACC30008Topic 3Rankin et al., 2e Ch5 & Ch2 (pp ?)Theories in accounting Adapted by Christine Jubb from slides accompanying text - John Wiley & Sons Australia Ltd

2. Learning objectives • Evaluate how theories can enhance our understanding of accounting practice • Integrate knowledge about PAT and agency theory and apply them to agency contracts between owners, managers and lenders to explain accounting practice and disclosure • Evaluate institutional theory in terms of its application to organisationalstructures and apply the theory to accounting practice and disclosure • Evaluate legitimacy theory and the notion of the social contract and apply it to accounting practice and disclosure • Evaluate stakeholder theory and apply it to accounting disclosure • Evaluate contingency theory in terms of its application to accounting practice and disclosure.

3. Presentation overview

4. Types of theories – 2 Types 1. Normative theories: • Not necessarily based on what is happening, but rather recommend what should happen. • Prescribe action required to attain a specific goal. • e.g. Conceptual Framework. 2. Positive theories: • Describe, explain, or predict activities based on real world observations • Help us understand why decisions have been made. • Lead to more informed decision-making. • e.g. contracting theory and agency theory.

5. Positive accounting theory Contracting theory: • Suggests an organisation can be characterised as a legal ‘nexus of contracts’ • Ownership (shareholders) is separate from control, and contractual managers are appointed by owners • Managers contract with lenders on behalf of owners to obtain debt funding • Both managerial contracts and debt contracts are used to manage these agency relationships

6. Positive accounting theory Agency theory: • Used to understand relationships whereby a principal (shareholders) employs an agent (manager) to: • perform some activity on their behalf • delegate decision-making authority to the agent • Can create a moral hazardif interests of agent and principal not aligned • There are 3 costs associated with relying on an agent to make decisions and conduct the business.

7. Positive accounting theory • Monitoring costs: • Incurred in measuring, observing and controlling the agent’s behaviour and include: • auditing of financial reports • setting up operating rules • establishing a management compensation plan • These costs are likely to be lower for an agent (manager) with a good reputation

8. Positive accounting theory • Bonding costs: • Incurred installing mechanisms to assure that agent’s decisions are in best interest of principals (shareholders), e.g.: • Incurring time and effort involved in producing and providing frequent accounting reports to lenders • Managers might also agree to not provide information to some external parties who may gain a competitive advantage from it.

9. Positive accounting theory • Residual loss: • Estimated monitoring and bonding costs are borne by agents through reduced remuneration (in a managerial contract) or higher interest rates (in a debt contract). • Divergence from these estimates is referred to as residual loss. • Residual loss is borne by both principal (shareholders) and agent (managers).

10. Positive accounting theory • Owner–manager agency relationships: • Agency theory identifies 3 main problems that can exist between managers and owners in an agency relationship: • horizon problem • risk aversion • dividend retention • Contracts and accounting information can be used to ‘bond’ interests of owners and managers to minimise these problems

11. Positive accounting theory 1. Horizon problem: • Managers and owners (shareholders) tend to have differing time horizons • Linking management rewards to longer-term (LT) entity performance reduces this problem • Moving manager’s focus from short‐term (ST) profitability to LT activities, designed to grow future cash flows, encourages managers to focus on LT performance.

12. Positive accounting theory • Risk aversion: • Managers are more risk averse than shareholders (S/H) • S/H can diversify their portfolios but managers’ livelihoods are tied to the entity • Increasing managerial share ownership increases a manager’s risk aversion, as it further decreases a manager’s ability to diversify risk • Salary and wealth are tied to success of the entity • Remunerating managers with a mix of cash and shares and limiting share‐based compensation as a manager’s ownership (insider ownership) in the company increases, is likely to encourage managers to invest in more risky opportunities.

13. Positive accounting theory • Dividend retention: • Managers prefer to maintain a greater level of funds within the entity, and pay less of the entity’s earnings to shareholders (S/H) as dividends • Linking bonuses to dividend payout ratioswill likely encourage managers to enhance dividend payouts to S/H • Linking bonuses to profits will encourage managers to seek additional profits, which are likely to be available for dividends.

14. Positive accounting theory • Manager–lender agency relationships: • When a lender agrees to provide funds to an entity the risk arises that borrower may not repay • In this instance the manager’s interests are completely aligned with those of owners • The agency problems that could arise include: • excessive dividend payments to owners, • underinvestment, • asset substitution • claim dilution

15. Positive accounting theory • Excessive dividend payments: • When lending funds, lenders price debt to take into account an assumed level of dividend payout • If managers issue a higher level of dividends, or excessive dividend payments,then this could lead to a reduction of the asset base securing the debt, or leave insufficient funds to service the debt.

16. Positive accounting theory • Underinvestment: • Problem arises when managers, on behalf of owners, have incentives not to undertake positive net present value (+ ve NPV) projects if the projects would lead to increased funds being available to lenders. • Covenants that specify the investment opportunities for which the organisation is able to use the funds are likely to alleviate this problem.

17. Positive accounting theory • Asset substitution: • Investment in alternative, higher‐risk assets may lead to higher returns to S/H • Lenders bear the risk of this strategy • Debt contracts often restrict investment opportunities of the entity • The lender might also secure debt against specific assets (i.e. provide collateral).

18. Positive accounting theory • Claim dilution: • When entities take on debt of a higher priority than that on issue, it is referred to as claim dilution • Most common method of avoiding claim dilution is to restrict borrowing of higher priority debt, or debt with an earlier maturity date

19. Positive accounting theory • Role of accounting information in reducing agency problems: • Accounting information forms one of the major components of both manager remuneration and lending contracts. • For managers, accounting information plays two roles in contracting process: • Writing the terms of managerial contracts • Determining performance against the terms of the contracts

20. Positive accounting theory • Information asymmetry: • Results when managers have an advantage over investors and other interested parties because theyhave more information about current and future prospects of the entity • Managers can choose when and how to disseminate this information • If entities did not provide information when other entities in the market did so, it would be assumed they had bad news to report and their share price would suffer as a result. • This is referred to as adverse selection.

21. Institutional theory • Institutional theory: • Used extensively in the management literature and increasingly used in accounting research to understand influences on organisational structures • Considers how rules, norms and routines become established as authoritative guidelines, and considers how these elements are created, adopted and adapted over time

22. Institutional theory • Institutional theory: • Proposes 3 main areas of influence, which leads to similarities across: • jurisdictions, • organisational fields, and • organisations (institutions) • referred to as isomorphism

23. Institutional theory Isomorphism – 3 types: • Coercive refers to pressures to conform to public expectations and demands 2. Mimetic refers to tendency to imitate other organisations viewed as successful. • Normative emphasises the collective values and beliefs that lead to conformity of actions within institutional environments

24. Legitimacy theory • Legitimacy theory: • Used to understand corporate action and activities, particularly relating to social and environmental issues. • Based on social contracts or social ‘licence’ • Society’s explicit and implicit expectations regarding the way businesses should act to ensure their survival • Organisations need to show they are operating in accordance with the expectations in the social contract

25. Legitimacy theory • Organisational legitimacy: • Explains process by which the social contract between business and society is maintained • Argues that organisations can only continue to exist if the society in which they operate recognises they are operating within a value system consistent with society’s own • Organisation must appear to consider rights of the public at large, not just its shareholders

26. Legitimacy theory Accounting disclosures and legitimation: Ways organisations obtain/maintain legitimacy: • Educate and inform society about actual changes in entity’s performance and activities • Change perceptions of society, but not actually change behaviour • Manipulate perceptions by deflecting attention from issue of concern to other related issues • Change expectations of performance • Legitimation can occur through performance or disclosure • Strategies taken by entities will differ depending on whether they are trying to gain, maintain existing, or repair lost or threatened legitimacy

27. Legitimacy theory • Accounting disclosures and legitimation: • Disclosure of information about an organisation’s effect on, or relationship with, society can be used in each of the strategies • Entity might provide information to offset negative news that may be publicly available • Organisations may draw attention to strengths, while playing down information about negative activities.

28. Legitimacy theory • Accounting disclosures and legitimation: Changing expectations of performance • Public reporting through annual reports/websites can be a powerful tool in showing that an organisation is meeting the expectations of society • One of the major functions of corporate reporting is to legitimate corporate operations • Legitimacy theory has commonly been used to explain disclosure of sustainability or corporate social and environmental information

29. Stakeholder theory • Considers relationships that exist between the organisation and its various stakeholders, rather than society as a whole. • Relates to the ethical or moral treatment of organisational stakeholders. • Stakeholders are individuals or groups who are affected by, or can affect, achievements of an organisation’s objectives.

30. Stakeholder theory • Organisational stakeholders:

31. Stakeholder theory • Characteristics of entities to which stakeholder theory can apply: • Voluntary associations: • formed to realize specified aims and purposes • allow members to freely exit (and freely eject other members from) the association. • attract and retain (as well as recruit and evaluate) members on the basis of their interest in advancing the association’s objectives • For‐profit entities • need to generate profits for S/H and other financiers • S/H might sell their shares in profit‐generating entities, while donors may decide whether or not to donate to a non‐profit entity • Both types of entity allow employees to freely leave

32. Stakeholder theory • Understanding of stakeholder theory has changed over past 5-10 years • Literature previously suggested 3 branches of the theory existed: • a normative theory, or ‘ethical branch’ • an instrumental branch • adescriptive or positive branch, often referred to as the managerial branch • It was proposed that: • organisations should treat all their stakeholders fairly and an organisation should be managed for the benefit of all its stakeholders • mechanism to explain how stakeholders might influence organisational actions • At times there will likely be conflicting interests, so it fell on management to partially sacrifice interests of S/H to meet those of other stakeholders

33. Stakeholder theory • Role of accounting information in stakeholder theory: • One important way of meeting stakeholders’ needs/expectations is providing information about organisational activities and performance. • As with legitimacy theory, stakeholder theory used to examine disclosure of voluntary information to stakeholders, most commonly relating to social and environmental performance.

34. Contingency theory • Contingency theory proposes that organisations are all affected by a range of factors that differ across organisations • Organisations need to adapt their structure to take into account a range of factors, such as: • external environment • organisational size • business strategy

35. Contingency theory • Contingency frameworks have been used to evaluate management accounting information and internal control systems. • They conclude that: • There is no universally appropriate accounting system that can be applied to all organisations. • Features of appropriate accounting systems are contingent upon the specific circumstances the organisation faces.

36. Comparison of theories (Ch 5):

37. Theories of regulation (Ch 2) • Accounting information is a ‘public good’. • some argue likely to be under produced without regulation • others suggest supply would exist without regulation • Competing theories regarding need for and intention of regulation • Signalling theory • Public interest theory • Capture theory • Bushfire theory • Ideology theory

38. Signalling theory • Suggests reporting entities can increase their value through financial reporting • Companies face a competitive capital market populated by sophisticated investors • Above-average entities motivated to show they are better than non-reporting entities • Non-reporting entities are perceived as of even poorer quality than before • Creates a virtuous cycle where regulation is not necessary

39. Public interest theory • Argues signalling theory relies on functioning of a perfect, free-market economy • Public interest theory assumes: • economic markets generally not perfect • regulation is virtually costless • Concludes that regulation: • is supplied in response to demands of the public • for the correction of inefficient or inequitable market practices

40. Capture theory • regulation is supplied in response to demands of self-interested groups • who are trying to maximise their incomes or interests • People are rational utility maximisers • Coercive power of government can be used to give valuable benefits to particular groups • Regulation can be viewed as a product governed by laws of supply and demand

41. ‘Bushfire’ theory • The political and public nature of regulatory influences • Takes into account: • reactions of users • society in general • ‘failures’ of regulatory processes • Regulations tend to arise from crises • Resulting rules do not necessarily deal with issues that caused the crisis • Rather they gain media exposure so that politicians are more likely to gain re-election

42. Ideology theory of regulation • relies on market failure • introduces role of lobbying in influencing actions of regulators. • Lobbying is a mechanism through which regulators are informed about policy issues • Predicts that effectiveness of regulation will depend on: • political ideologies of the regulators • impact of special interest lobby groups

43. Using theories to understand accounting decisions • e.g. Expensing or capitalising costs: • Agency theory: • Managers with bonuses linked to a current measure of entity performance, like profits, will aim to maximise profits. • Where entity has a lending agreement with a leverage covenant, managers will want to ensure value of assets is maximised, which will lead to capitalising costs where possible. • Institutional theory: • Entities would be expected to follow industry practices that are perceived as ‘normal’, in: • expensing or capitalising • setting pay and using a mix of cash and incentive pay.

44. Using theories to understand accounting decisions • Accounting estimates: • Accountants and managers constantly estimate economic magnitudes to bring to account. • Estimates can lead to substantial variations in reported profits and asset balances. • Agency contracts can explain managerial decisions as managers and accountants are likely to ensure their own bonuses are maximised and the entity is not at risk of breaching debt contracts.

45. Using theories to understand accounting decisions • Disclosure policy: • Beyond the specific standard and legal requirements, managers and accountants decide the extent and location of voluntary disclosures within annual or other reports. • Under stakeholder theory, these disclosures help to maintain relationships with powerful stakeholders • Under legitimacy theory, they are a way of maintaining or regaining legitimacy

46. Summary Theories enhance our understanding of accounting practice and decisions made by accounting practitioners: • PAT and agency theory through application to agency contracts between owners (S/H),managers and lenders (to explain accounting practice and disclosure). • Institutional theory in terms of its application to organisational structures, to accounting practice and disclosure. • Legitimacy theory and notion of social contract and its application to accounting practice and disclosure. • Stakeholder theory and its application to accounting disclosure. • Contingency theory and its application to accounting practice and disclosure.

47. Summary • Regulatory theories • Signalling theory • entities can increase their value through financial reporting • Public interest theory • regulation is supplied in response to demands of the public for correction of inefficient or inequitable market practices • Capture theory • Coercive power of government can be used to give valuable benefits to particular groups • Bushfire theory • Regulations arises from crises and are implemented so that politicians are more likely to gain re-election • Ideology theory • Lobbying is a mechanism through which regulators are informed about policy issues