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POSITIVE ACCOUNTING THEORY

Agency Theory
- With resolving problems that exist in agency relationship; that’s, between principal and agents of the
principals
- Shareholder wish for management to run the company in a way that increase the interest of them but in
management will, they wish to grow the company in ways that increase their personal power and wealth and
are not necessarily in the best interest of shareholder
- Always divergence between an agent’s decisions and those decisions might benefit the welfare of the
principal
- Agency cost arises because of the core problems conflicts of interest
- Costs include the costs of monitoring, costs bonding, residual losses, free cash flows and debt costs in where
a monitoring cost is to let principal observe and control the agent’s behavior
 Monitoring costs are the costs of monitoring the agent’s behavior, e.g. auditing F/S
 Bonding costs are those costs incurred by the agents to provide assurance to the principal that they are
acting in the principal’s best interests
 Residual loss is the wealth effect of the fact that, even with monitoring and bonding expenditures,
actions taken by an agent will sometime

Shareholders – Manager Agency Problems


1. Risk – Aversion Problem
A. Managers
- Prefer to invest in less risky, lower NPV project because they have significant undiversified human
capital invested in the business they are managing
- Averse to the investment in the mine because if it failed, the value of their most valuable asset – human
capital – would fall and they may lose their job
- Prefer to minimize their own risk rather than maximize the value of the firm
B. 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.
2. Dividend – Retention Problem
Managers
- Prefer to pay out less dividends than shareholder prefer
- Retain the money in business to pay for their own salaries and benefits and increase the size of the empire
they control
- Prefer to retain the funds in order to increase the size of the firm under its management and increase the
scope of their power
3. Horizon Problem
- 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
Shareholder – Debt Holders Agency Problem
1. Excessive dividend payment (retention): Less risky to pay is cash. Cash makes dividend risk weak. High
dividend payout ratio will leave just a small percentage of profits to plow back into the business. It will result
in either a decreasing cash position or a rising debt load.

2. Asset substitution problem: Lenders are risk-averse (low risk assets - building/inventory - low
return).However, managers tend to invest in higher risk assets (e.g. mining) to increase the potential returns
to shareholders.

3. Claim dilution: occurs when the firm issues debt of a higher priority than the debt already on issue

4. Underinvestment: Shareholders choose to invest high-risk high-profit assets instead of low-risk investments
will provide a safe cash flow to better off debt holders. Shareholders can pay debt-holders more money (as
higher return from high-risk assets) to cover the debt.

Positive Accounting Theory


- Concerned mainly with ‘explaining’ the reasons for current practice and ‘predicting’ the role of accounting and
associated information in the economic decisions
3 Hypothesis
1. Bonus Plan Hypothesis: (1) managers will use accounting policies that are likely to shift reported earnings
from future periods to the current period, (2) maximize their personal compensation as by reporting a high net
income, their utility will be maximized through bonuses and incentives.

2. Debt covenant hypothesis: (1) to compromising their debt covenants, the more likely management is to use
accounting policies that shift reported earnings from future periods to the current period, (2) higher net
earnings will reduce the probability of technical default on the debts.

3. Political cost hypothesis: (1) to use accounting policies to defer reported earnings from current periods to
future periods. This hypothesis brings politics into the choice of accounting policies. Highly profitable firms
attract media and consumer attention. This attention can create an increase in taxes and other regulations.

2 Perspective
1. Efficiency perspective / ex ante perspective: (1) how contracting mechanisms minimize agency and
contracting costs of the firm;(2)Managers select accounting methods which most efficiently reflect underlying
firm performance, best method for monitoring, reduce risks of investors and decrease cost of capital
2. Opportunistic perspective / ex post perspective: (1) seeks to explain managers’ actions once contracts are
already in place, (2) initially be selected for efficiency reasons, but once they have been negotiated agreed,
then managers will aim to utilize accounting choices in a way that best serves their own interest

Debt Covenants : T&C written into debt contracts that restrict the activities of management or require
management to take certain action
Covenants contain in debt contract fall into 4 categories:
1. Covenants that restrict the production investment opportunities – to reduce assets substitution and under
investments
2. Covenants restraining dividend policy and typically restricting dividend to a function of net income – to deter
excessive dividend payments
3. Covenants restraining the financing policy of the firm – aimed at the claim dilution problem and usually take
the form of restricting leverage
4. Bonding covenants which may require the firm to provide certain info to bond holders such as FS reports and
disclosure to regulatory authorities – assist bond holders in determining whether covenants have been violated
ACCOUNTING REGULATION

Public Interest Theory


- Government use this theory to overcome market failure
- Regulation is intended by legislatures to protect consumer interest and improve economic performance
- Potential market failure → lack of competition, barriers to entry, information gaps between buyers and
sellers
- Public interest theory is based on the assumption that economic market are subject to market imperfections
or transaction failure, if left uncorrected will cause inefficient and inequitable outcomes
- 3 assumptions
a. Consumer interest is translated into legislative action through operation of internal market place
b. There are agents who will seek regulations on behalf of the public interest
c. The government has no independent role to play in the development of regulations
- Accounting information is considered as a public good
- Monopolies → market failures → price mechanism that regulates supply and demand breaks down
- Governments regulate markets, when markets are unable to regulate themselves
- Government intervention in accounting standard process is to rectify failures themselves
- Corporate collapses → serious violation of competitive conditions

Regulatory Capture Theory


- 2 assumptions
i. All members of society are economically rational
a. Each individual will pursue his/her self-interest to the point where the private marginal benefit from
lobbying regulators equals the private marginal cost
b. People lobby for regulations that increase their wealth
ii. Government has no independent role to play in the regulatory process and that interest groups seek to
battle for control the government coercive power to achieve their desired wealth distributions
- 4 situations in which capture may occur
a. Control the regulation and regulatory agency
b. Succeed in coordinating the regulatory body’s activities with their own activities so that their private
interest is satisfied
c. Ensure non-performance by the regulating body
d. Mutually shared perspective, giving them the regulation they seek
- Regulation become on instrument to protect regulated body
- Public interest is not protected because regulated control or dominate the regulator
- Difficult for regulatory body to remain independent because survival depends on its policies being accepted
by the group being regulated
- Regulatory decisions have major effects on the regulated industries interest
- Regulatory agencies has power to grant or deny an organization to operate
- Regulatory decisions can affect regulated industries overall financial position ** non industry group stake in
regulatory bodies is very small
- In this theory, professional accounting bodies or corporate sector seek to control as much as possible in
setting of accounting standards
- Profession could legitimize accounting standards and main economic interest by capturing MASB in M’sia
Private Interest Theory
- Assumptions : the regulations comes into existence as a result government response to public demand to
rectify inefficient or inequitable practices by individuals and organizations
- Government has power to coerce
- Power to coerce is a potential resource or threat to every business firm
- Politicians are not neutral arbiter
- Regulations sought by private interest groups
- Governments are not independent arbiters but rationally self interest
- Governments sell aspects of their right to coerce others on the form of supplying regulatory program and
legislation
- Group with highest bid will be successful → producer group
- Producer group use power of government to their own advantage → the party who can support wealth of
organization
- Consumer and public interest group has limited ability to make effective bid, due to cost of organization and
information cost
- The regulation is sought by the private interest group and regulation is designed and operate for its benefits
RECOGNITION AND MEASUREMENT : CAPITAL MAINTENANCE
Current Cost Accounting
- Amount that would be paid now to acquire the best asset available to undertake the function of the asset
owned

Objective of Current Cost Accounting


With regard to profit, managers often face two decisions
Holding decision : hold assets/liabilities or to dispose them
Operating decision ; how to use and finance them

Manager will examine


- The current operating profit
- The excess of the current value of the output sold over current cost of the relate input
- Realizable cost saving
- Increases in the current cost of assets held by firm in the current period
- Holding gains/losses whether realized/unrealized
*the business profit is therefore, calculated on real basis

Arguments for and against Current Costs


1. Recognition principle
- Violates the conservatism principle – but actual phenomena
- Are holding gains profits or revaluation adjustments?
- Unrealized holding gain represents actual economic phenomena occurring in the current period and
therefore should be recognized if there is sufficient objective evidence to support price changes
- Determination of periodic income based on what actually happens in the current period
2. Objective of current cost
- Lacks objectivity : prescribe procedures for the determination of current costs/market price easily to
obtain
- Current cost of fixed assets involves some complex issue, however current cost will frequently can be
available from second hand dealers/used market/secondary market
3. Technological Change
- Current operating profit representative of the long term profit capability, assuming current condition
relatively the same
- They appears to ignore technological advances
- Future operation may be based on different set of techniques then operating profit today not be a valid
indicator for future operating profit

Current Exit Price (Fair market value)


- Amount received from selling an asset either to a market for new commodity or to a second-hand market.
- Two major departures from historic cost accounting:
 The values of non-monetary assets are selling prices and any changes are included in profit as unrealized
gains
 Changes in the general purchasing power of money affect both financial capital and profits
Argument for Exit Price Accounting
1. Provides relevant and reliable information
- There is one way to determine profit that is superior to all others
- Profit is the difference between capital at two points in time exclusive of additional investments by and
distributions to owners
- To be relevant, information must be useful in the decision models of accounting data users
- The present selling price is the only item of information that is relevant to all decisions
2. Profit concept
- Does not provide a meaningful concept of profit
- Does not provide relevant data to match against revenue to measure success or failure
- The critical event does not relate to the performance of the firm
- Does not produce realistic financial reports
3. Additively
- If we use different measurement systems then no practical or commercial meaning can be deduced from
the aggregate
- Even if we use historic cost accounting as the sole measurement system, the jumble of historic costs on
different dates means we cannot put any meaning on the calculation of net assets or profit
- Current Exit Price does not have this problem since it self-consistent

Concept of Capital Maintenance


Financial Capital Maintenance Physical Capital Maintenance
A profit is earned only if the financial or money A profit is earned only if the physical productive
amount of the net assets at the end of period exceeds capacity of the entity at the end the period exceeds the
the financial (or money) amount of net assets at the physical productive capacity at the beginning of the
beginning of the period after excluding any period, after excluding any distributions to or from
distributions to or from owners during the period owners during the period

Capital represents the cash invested by the owners plus Capital maintenance involves maintaining the firm’s
profits reinvested by retention in the business-relate to operating capacity to replace the assets the firm had at
general price level the start of the period

Profit is the amount of cash available to the owners Profit is only earned after the firm’s ability to replace
after maintaining the purchasing power of the business the opening assets has been maintained

Proprietary theory – company’s purpose is to increase Entity view, the main requirement is to maintain the
owner’s wealth ability of the entity to carry out its functions
MEASUREMENT
CURRENT ISSUE
Theoretical Understanding
1. Social Contract Theory
- Explain that there are boundaries of acceptable interaction between participants within the society and will
determine the practices that are acceptable or unacceptable in meeting the needs of the society
- Management, via its social contract with various stakeholders, aims to perform socially desirable actions in
return for acceptance of its company objectives
- Management actions are guided by social expectations of their performance
- For those companies who disregard the boundaries of socially desirable behavior, society will allow the
formation of governments with power to regulate and restrict the activities of these companies

2. Legitimacy Theory
- Explain the reaction of management towards changes in community expectations. Management is said to
behave in a way to avoid further explicit restrictions on their operations
- Corporate legitimacy not only involves matching performance with expectations, it is also about the means
by which management can inform external parties about their performance in social and environmental
performance
- Management may attempt to justify its current actions by communicating its commitment to improve
environmental management and performance. Management can also try to change the stakeholders’
expectations that it considers unreasonable.

3. Stakeholder Theory
- Stakeholder theory is a rebuttal of notion that a business only has social responsibilities to make profits on
behalf of shareholders
- Changes in business environment and company law have given rights to all those groups that have claims
on the company, such as customers, suppliers, employees, government authority, and lobbyists
- Specifically, explains that the behavior of an organization are governed by :
 The nature of its diverse stakeholders
 The norms defining right or wrong adopted by these stakeholders
 Stakeholders’ relative influence on organization decisions

4. The Political Economic Theory


- Suggests that accounting systems act as mechanism used to create, distribute and mystify power, where
accounting reports serve as a tool for constructing, sustaining and emphasis added economic and political
arrangements, institutions and ideological themes which contribute to the corporation’s private interest
- Corporate reports as a product of the interchange between the corporation and its environment
- How institutions develop in different social and economic systems
Reactions of Capital Markets to Financial Reporting
Capital markets Research
- Asks how do securities markets react to accounting information
- Look at the macro level of aggregate securities markets
- Based on economics and assume everyone is a rational wealth maximize

Behavioral accounting Research


- Asks how do people actually use and process accounting information
- Focus on the micro level of individual managers and firms
- Based on psychology, sociology and organizational theory and generally makes no assumptions about how
people behave

Efficient Market Hypothesis


- Financial markets are “informationally efficient”. Prices on traded assets already reflect all known
information, and therefore are unbiased in the sense that they reflect the collective beliefs of all investors
about future prospects.
- EMH is drawn on microeconomic price theory, which emphasizes on supply and demand, equilibrium
analysis and competitive market
- Three forms of market efficiency
 Weak form prices reflect info about past prices and trading volumes
 Semi-strong form all publicly available information is rapidly and fully impounded into share prices in
an unbiased manner when released
 Strong form security prices reflect all info
Result of Capital Market Research (Ball and Brown)
1. Historical Cost income is used by investors
- Tested whether firms with unexpected increases in accounting earnings had positive abnormal returns,
and firms with unexpected decreases had negative abnormal returns
- Information contained in the annual report, prepared using historical cost was useful to investors
- Anticipation of earnings changes by investor indicates that investor obtain much information useful for
investment decision making from other sources other than annual earnings announcement
2. Extent of alternative information sources
- Information content varies between countries and companies
- Less alternative sources of information for smaller firms than larger firms
3. Relative magnitudes of cash and accruals
- Under the accrual system some items are recognized before the cash flows are received or paid while
others are recognized on a periodic basis
 The process involves adjusting the timing of when the cash inflows or outflows are recognized to
achieve a matching of revenue or expenses
 Accrual system can be subjective rather that objective and therefore different earnings figures can be
achieve depending on application of accrual system
- Share prices found to act as if investors “fixate” on reported earnings without taking into consideration the
relative magnitudes of cash and accrual components
- Earnings can be managed for only a limited period of time as earnings will eventually lower as the
accruals subsequently lower
4. Information announcements of other firms
- Earnings announcement by one firm also result in abnormal returns to other firms in the same industry –
information for each industry is relative similar → known as ‘information transfer’ effect – reduces the
surprise element in earning announcements
- The direction of capital market reaction is related to whether the news reflects a change in conditions for
the entire industry, or changes in relative market share within the industry
 Information regarding about sales/earnings changes result in a price reaction for other firms in the
industry
 It is important to consider the timing of information of earnings announcements as it forms an
expectation about how information is released since information can be gained from the information
releases of similar companies.
5. Benefits of Voluntary Disclosure
- The disclosure of information over and above the information required according to regulation
- Voluntary disclosures include those in annual reports as well as media releases
- Firms with more disclosure policies have
 Larger analyst following and more accurate analyst earnings forecasts
 Increased investor following
 Reduced information asymmetry
 Reduced costs of equity capital
6. Size
- Relationship between earnings announcements and share price movements is inversely related to the size
of the entity
- Earnings announcements found to have a greater impact on share prices of smaller firms than larger firms
- More information generally available for larger firms
 Therefore, there is a greater likely that projections about earnings have already imploded the share price
 Larger firms tend to have more information circulated about them as they attract interests for external
parties
- Earnings announcements from larger firms are more anticipated as they provide less surprises as the share
price has already reacted prior to information being released
CONCEPTUAL FRAMEWORK

Accounting Postulate
1. Entity Postulate
- The entity postulate assumes that the financial statements and other accounting information are for the
specific business enterprise which is distinct from its owners. Attention in financial accounting is focused
on the economic activities of individual business enterprises.
- This postulate hold that each enterprises is an accounting unit separate and distinct from its owners and
other firms
- Report the entity’s transaction rather than personal transaction
- Recognize the fiduciary duties of management to shareholders
2. Going-concern Postulate
- The business entity will continue its operations long enough to recognize its projects, commitments and
ongoing activities
- This postulate assumes that the entity is not expected to be liquidated in the foreseeable future or that the
entity will continue for an indefinite period of time
3. Unit of Measure Postulate
- Accounting is measurement and communication process of the activities of the firm that are measureable in
monetary term
- Limitations apply
 Accounting is limited to the prediction of information expressed in terms of the monetary unit
 Accounting does not record or communicate other relevant information
 Accounting period Postulate
 Holds that the financial reports depicting changes in the wealth of a firm should be disclosed
periodically
 It imposes accruals and deferrals

The Theoretical Concept


1. The proprietary theory
- The entity is the ‘agent, representative or arrangement through which the individual entrepreneurs
(proprietaries) or shareholders operate’
- The proprietor group as the center of interest is reflected in the ways which accounting records are kept
and FS are prepared
2. The entity theory
- Views the entity as something separate and distinct from those who provide capital to the entity, where to
sees the business unit, rather than the proprietor as the center of accounting interests
3. The fund theory
- The basis of accounting is neither the proprietor nor the entity, but a group of assets and related
obligations and restrictions called a ‘fund’
- It’s useful primarily to government and NPO.
Accounting Principle
1. Cost Principle
- The acquisition or historical cost is the appropriate valuation basis for recognition of acquisition of all
goods and services, expenses, costs and equities.
- The cost principle is justified both in terms of its objectivity and the going-concern postulate :
 Acquisition cost is objective, verifiable information
 The entity will continue indefinitely, therefore current values or liquidation values for asset valuation are
not necessary
2. Revenue Principle
- The nature and components of revenue : an inflow of net assets resulting from the sale of goods or
services / an outflow of goods or services from the firm to its customers
- The measurement of revenue : Measured in terms of the value of the products and services exchanged in
an arms-length transaction
- Timing of revenue recognition : it must be severed from capital/ in the form of liquid assets
3. Matching Principle
- Expenses should be recognized in the same period as the associated revenues
- Association between revenues and expenses depends on one of 4 criteria :
 Direct matching of expired costs with revenue
 Direct matching of expired costs with the period
 Allocation of costs over periods benefited
 Expensing all other costs in the period incurred, unless they have future benefit
4. Objectivity Principle
- It holds that the usefulness of financial information depends on the reliability of the measurement
procedure used
- There are different interpretations of this objectivity
 An objective measurement is an impersonal measure
 An objective measurement is a very viable measurement
 An objective measurement is the result of consensus among a given group of observers
 The size of the dispersion of the measurement distribution may be used as an indicator of the degree of
objectivity
5. Consistency Principle
- It holds that similar economic events should be recorded and reported in a consistent manner from period
to period
- It makes financial statements more comparable and more useful
6. Full-disclosure Principle
- It holds that no information of substance or of interest to the average investor will be omitted or concealed
- It is enforced by various disclosure requirements within the accounting standards
7. Conservatism Principle
- It holds that when choosing between two or more acceptable accounting techniques, some preference is
shown for the option that has the least favorable impact on shareholders’ equity
- At present, the emphasis on objective and fair presentation has lessened the reliance on conservatism
8. Materiality Principle
- Transactions and events having insignificant economic effects need not be disclosed
9. Uniformity and Comparability Principle
- Consistency principle refers to the use of the same procedures for related items by a given firm over time
- Uniformity principles refers to the use of the same procedures by different firms
- The objective is to achieve comparability of F/S by reducing the diversity created by the use of different
accounting procedures by different firms.
ACCOUNTING ENVIRONMENT
Pragmatic Theories
- Based on observation of the behavior of the accountants or the users of the information generated by the
accountants
- Theories that seek to explain and predict particular phenomena → talk about accounting policy choice, e.g.
legitimacy theory, stakeholder theory etc
- Inductive approach – Conclusion from specific to general statement
A. Descriptive Pragmatic Approach
 Based on observed behavior of accountants
 Tested by observing whether accountants do act in the way the theory suggests
B. Psychological Pragmatic Approach
 Theory depends on observations of the reactions of users to the accountants’ outputs

Normative Theories
- Focus on deriving the “true income” for an accounting period, or on discussing the type of accounting
information which would be useful in making economic decisions
- Based on value judgment or personal opinion, and these value judgment cannot be verified or tested
- Prescribe how a particular practice should be undertaken
- Deductive approach – Conclusion from general to specific statement

Positive Theories
- Hypotheses are tested against actual events
- Test theories that assume that accounting information is an economic and political commodity

Normative v Positive
Normative theories are prescriptive
Describe how accountant should behave to achieve an outcome that is judged to be right and good income

Positive theories are descriptive, explanatory or predictive


Describe how people do behave regardless whether it is right, explain why people behave in certain manner or
predict how people will react/do?