Positive theory of accounting policy and disclosure

Contracting theory
Contacting theory characteristic the firm as a legal nexus (connection) of contractual
relationship among suppliers and consumers of factors of production. The firm exist because
it costs less for individuals to transact( or contract) through a central organization than to do
so individually.
In a more general sense, rather than all individual suppliers of the factors of production (land,
labor and capital) individually contracting with consumers for heir output, contracts are
struck by the the firm between classes of suppliers and consumers of factors. There are, for
example, contracts:
documenting the terms and conditions of employment of managers by shareholders
documenting the terms and conditions under which lenders provide financial
resources
of employment for factory and other workers
for the supply of goods
for the sale and delivery of goods and services.
Thus, one we allow for the reality of contract transactions costs, including financial and non
financial costs of negotiating the terms of the sale of milk from a dairy farmer, Coase argues
that firms will exist. The reason is that firms are the most efficient form of contract nexus in
organizing and coordinating economic activity and reducing contracting costs. Although it is
important to recognize that firms involve a multiplicity of contracts, positive accounting
theory usually focuses on two types of contract: management contracts and debt contracts.
Both of these contracts are agency contracts and agency theory provides a rich source of
explanation for existing accounting practice.
Agency theory
In such a situation, both the principal and the agent are utility maximize and there is no
reason to believe that the agent will always act in the principals best interests. The agency
problem that arises is the problem of inducing an agent to behave as if he or she were
maximizing the principals welfare. For example, where the agent is the firm manager, the
manager has incentives to increase consumption of perquisites such as the use of a company
car, expense account, or the size of bonus payments at the expense of the principal.
Alternatively, the manager (agent) may seek to avoid personal stress from overwork and not
be as conscientious as possible in endeavors as possible in endeavors to maximize the firms

value. Because the agent has decision making authority. He or she can transfer wealth in this
manner from the principal to the agent if the principal does not intervene.
This agency problem, in turn, gives rise to agency costs. At the most general level, agency
costs are the dollar equivalent of the reduction in welfare experienced by the principal owing
to the divergence of the principals and the agents interests. Jensen and Meckling divide
agency costs into:
monitoring cost
bonding cost
residual costs
The appeal of agency theory lies in the fact that it attributes a role for accounting a s part of
the bonding and monitoring mechanisms which is closely related to the traditional
stewardship role of accounting. Our attention is now directed to specific agency relationship,
particularly those which have been considered routinely by positive accounting theory.
Reference is also made to the use of accounting numbers in the contracts between the
contracting parties.

Price protection and shareholder/ manager agency problems

The separation of ownership and control means that managers as the agents of shareholders,
can act in their own interests but agents interest may be contrary to the interest of the
shareholders. Partial ownership or non ownership of a firm by management provides
incentives for managers to behave in a manner contrary to the interests of shareholders
because management does not bear the full cost of any dysfunctional behavior.
Reason for differences in shareholders and managers incentives regarding firm policies
represent a number of specific problems. These problems include the risk aversion problem,
the dividend retention problem and the horizon problem. The risk aversion problem means
that managers prefer less risk than do shareholders. 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. By investing in a variety of firms or types of investments,
shareholders can minimize their exposure to investment risk from any one source.
Diversifying their investments in this manner tends to hedge their exposure to risk of loss
from their investments. Shareholders risk aversion is further reduced by the fact that limited

liability means that they have no obligation to cover future decrease in firm value except to
the extent that their shares are not fully paid. Since their claim against the firm is essentially
an option against the future value of the firm, their interest are best served if management
invests in certain risky projects in order to maximize the value of the business.
Shareholder-debt holder agency problems
Smith and Warner recognized that the agency problem of debt can give rise to four main
methods of transferring wealth from debt holders to shareholders:
excessive dividend payments
asset substitution
underinvestment
claim dilution
The excessive dividend payment problem arises when debt is lent to a firm on the assumption
of a certain level of dividend payout. Debt is priced accordingly, but the firm then issues a
higher level of dividends. Issuing higher dividends reduces the asset base securing the debt
and reduces the value of the debt.
Asset substitution is based on the premise that lenders are risk averse. They lend to a firm
with the expectation that it will not invest in asset or projects of a higher risk than that which
is acceptable to them. They price debt accordingly, via the rate of interest charged or the term
of the loan. After all, they do not share in the increased returns that high-risk projects can
provide. However, they do share in the possible looses to the extent that the looses reduce the
security available to meet their claims.
Underinvestment occurs when owners have incentives not to undertake positive NPV project
because to do so would increase the funds available to the debt holder but not to the owners.
Claim dilution occurs when the firm issues debt of a higher priority than the debt already on
issue. This increases the funds available to increase the value of the firm and the value of the
ownership interest, but it decreases the relative security and value of the existing debt.

Ex post opportunism versus ex ante efficient contracting

Ex post opportunism occurs when, once a contract is in place, agents take actions that transfer
wealth from principals to themselves. In contrast, efficient contracting occurs when agents
take actions that maximize the amount of wealth available to distribute between principals
and agents and the information perspective simply argues that managers provide information
to existing and potential investors with the intention of providing the best information
possible to help decision making. Signaling theory relates to each perspective by predicting
that managers will provide information that forms the basis for expectations reflected in
contractual terms or investment decisions.

Signaling theory
The information hypothesis is aligned with signaling theory, whereby managers use the
accounts to signal expectations and intentions regarding the future. According to signaling
theory, if managers expected a high level of future growth by the firm, they would try to
signal that to investors via the accounts. Managers of other companies that are performing
well would have the same incentive and managers of firms with neutral news would have
incentives to report positive news so that they were not suspected of having poor results.
Managers of firms with bad news would have incentives to report their bad news, to maintain
credibility in effective markets where their shares are traded. Assuming these incentives to
signal information to capital markets, signaling theory predicts that firms will disclose more
information than is demanded. The logical consequence of signaling theory is that there are
incentives for all managers to signal expectations of future profits because, if investors
believe the signals, share prices will increase and the shareholders will benefit.
Political processes
Positive accounting theory also models the political process involving the relationship
between the firm and other parties interested in the firm, such as government, trade unions
and community groups. As in the context of debt and management compensation contracting,
accounting is important in the political process as one of the sources of information about
firms.
The major difference between the political market and the capital market is that there is
generally less demand and therefore less incentive for the production of information in

political markets. Economic analysis suggests that this results from the lower marginal
benefit to individuals in the political process, because it is harder for individuals or groups to
capture benefits from that information. There are high information costs to individuals,
heterogeneity (diversity) of interest and organizational costs.
Conservatism, accounting standards and agency costs
Conservatism arises because there is an asymmetric verification requirement that imposes a
higher degree of verification for revenues when compared to expenses and this generally
serves to reduce reported earnings. Further, the valuation system was based on historical costs
and revaluations were not allowed in the United states. Moreover, the use of conservative
historical costs effectively means that any increased asset values will leak into earnings as
they are realized through transactions rather than through the immediate jump in value. This
was a reaction against some aggressive accounting methods used in the 1920s.
Additional empirical tests of the theory
Empirical tests provide evidence that managers use accounting numbers to counter political
pressure to gain political advantages such as export credits to set targets for managers that
have upper and lower compensations limits, to reduce debt covenants, to provide dividend
constraints and to generally play a significant role in constraining management manipulation.
Evaluating the theory
Positive accounting theories have been criticized on the grounds of their usefulness, their
methodological and statistical rigor and their philosophy. In response, positive accounting
researches argue they develop a theory that has an information role that is managers, auditors,
lenders and others demand theories that help them to predict the effects of accounting choices
on their welfare and in setting up efficient contracts. Moreover, through its contribution to
explanation and prediction, positive theory helps parties such as standard setters to
understand the consequence of their actions in removing the conservative bias of accounting
practices.
Issues for auditors

Auditors have a bonding and monitoring role in agency theory. Auditing is now a legal
requirement but there is evidence that auditing was voluntarily undertaken in the past.
Researches has also shown that higher quality auditors are demanded in situations where
clients wish to signal that their accounts are of higher quality or where there are severe
agency conflicts or weak control mechanisms. Industry specialist auditors are able to demand
higher audit fees and clients demand research and development contract specialist auditors
when firms have highly discretionary expenditures on research and development growth
options.