Financial Accounting Theories

Positive Accounting Theory: is a theory concerned with explaining particular accounting practice to predict the choice which firms make with respect to particular accounting methods. PAT focuses on the relationships between various individuals who provide resources to the organization, focuses on the relationships between the owners and the managers or between the managers and the firm’s debt holders, involve the delegation of decision making from one party to another party (agency relationship), lead to a loss of efficiency and increased costs. A central assumption of PAT is all individuals are driven by economic self-interest and therefore will act in an opportunistic way. Firm managers act as agents for the owners of the company and are individuals that act opportunistically for their own economic self-interest the managers may make choose accounting methods (policies), E.g. to increase reported sales/profits for the purpose of increasing their own remuneration. This will not necessarily be to the benefit of the owners since it will redirect cash reserves otherwise available to pay dividends. It would be ideal for financial statements to be objective and free from bias, however the reality is that this may not happen within the theoretical confines of PAT.

Efficiency perspectives of PAT: using contracting mechanisms, it can be put in place to minimise the agency costs of the firm, the costs associated with assigning decision making processes to an agent. E.g. remuneration plans tied to performance of the firm, to align the interests of managers and owners, both parties will benefit if the firm performs well. Smoothing reported profits may reduce the perceived risk of the firm which leads to lower cost of capital.

Opportunistic perspectives of PAT: given the negotiated contractual arrangements of the firm and seeks to explain and predict certain opportunistic behaviours that will subsequently occur. E.g. managers may manipulate accounting numbers by adopting particular accounting methods to improve their apparent performance and their bonus. Managers receiving bonus based on profits choose to smooth reported profits. It can increase the possibility of getting a bonus during poor performance period.

Agency Cost: 1) Monitoring costs: costs incurred to monitor the managements performance, e.g. cost of audit. 2) Bonding costs: costs incurred to bond the management to act in the interests of owners/debt holders, e.g. cost of prepare financial report. 3) Residual cost (residual loss): wealth loss when the management does not always act in the owners/debt holders interest.

Market based bonus schemes: Tied to market price of the firm’s shares, e.g. shares or option to shares. If the value of the firm’s shares increases, both managers and owners will benefit, managers will be given an incentive to increases the value of the firm.