The Framework and Conflict Resolution in Accounting Theory

School: University of New South Wales - Course: ACCT 3563 - Subject: Accounting

Tutorial 2: Accounting Theory Framework for Accounting Theory: •Normative Accounting Theory: Prescribe what should happen in accounting oEthical theories oThe Conceptual Framework & Accounting Standards oContinuously Contemporary Accounting (CoCoA). Measures all assets and liabilities at exit price (selling prices), with an adjustment to equity for general inflation (if any). Used only in AASB 140 Agriculture. oInflation accounting systems: Covered in AASB 129 but not used in Australia. •Positive Accounting Theory: Explain/predict existing accounting practices oSeparation of ownership & control in firms oAgency conflicts with equity and with debt oRole of monitoring & bonding oResidual loss oPolitical costs oOpportunism vs contracting efficiency oSignalling •Systems oriented theories oStakeholder Theory oLegitimacy Theory oInstitutional Theory •Roles of legal system, enforcement, and culture in explaining accounting practices Positive Accounting Theory 1.Overview oPAT seeks to explain and predict accounting practice. It focuses on the relationships between certain classes of stakeholders involved in providing resources to an organisation. oAssumptions: oSelf-interest maximising oRational behaviour oSemi-efficient markets oPrice protection - markets adjust prices to reflect the actions of managers oThese actions lead to agency costs of debt and equity. oThe value of the firm = value of equity + value of debt. 2.Agency conflicts & problems Could have separation of 1) management and 2) provider of equity and debt financing or separation of 1) inside shareholders and 2) outsider equity and debt holders. 1)Conflicts betweeninsidersandoutside equity holders(e.g., shareholder-manager): oDifferences in risk aversion Managers generally prefer less risk than shareholders. oShirking Laziness, inefficiency, incompetence Insiders tunnel firm's funds to themselves Non-arms length transactions (fraud) Insiders consume excessive perquisites (non-cash benefits) oHorizon problem Insiders have short term focus; outsiders have long term focus. oOver-retention of profits / Dividend retention Managers prefer to retain funds within the organization for growth, but shareholders prefer increased dividends. 2)Conflicts also arise betweeninsidersandcreditors(e.g., debtholder-manager): Insiders try to maximise value of equity rather than value of firm (debt + equity). oExcessive dividend payments Payment of excessive dividends may result in the organization having insufficient funds to service debt. oClaim dilution Take on a debt of equal or higher priority after entering an initial debt (e.g., taking on a secured loan when an unsecured loan is already in place). oAsset substitution Investment in risker assets after a loan has been arranged. Lenders share the "downside" risk but not the "upside" risk. oUnderinvestment If an entity is in financial difficulty, it has little incentive to engage in positive NPV projects because creditors rank higher than shareholders in the event of liquidation oExcessive management perquisites and shirking can also be considered agency costs of debt if they lead to debt default.