financial accounting theory

This essay is to critically evaluate the usefulness of the accounting theory to practicing accountants today. It will provide a general assessment of information asymmetry and the fundamental problem of accounting, and it will also briefly discuss the normative and positive accounting theories and their usefulness to practicing accountants. After those discussions, it will specifically discuss the strength and limitation of positive accounting theory and assess its usefulness to practicing accountants.

Critically evaluate means that it must discuss the strengths and limitations of the topic. Therefore, evaluate the usefulness of accounting theory to practicing accountants today must discuss the advantages and the disadvantages of the accounting theory. To be usefulness, accounting theory should include the stewardship and information roles. It means that accounting theory should provide the relevant and reliable information to practicing accountants. First of all, it is important to understand what accounting theory is and who the practicing accountants are.

The practicing accountants should include those people who work in or relate to the accounting, such as the financial accountants, management accountants, auditors and regulators. Hendriksen (1970, p. 1) defined the accounting theory as: …logical reasoning in the form of a set of board principles that (1) provide a general framework of reference by which accounting practice can be evaluated and (2) guide the development of new practices and procedures. Normative theories and positive theories are the two major parts of accounting theory.

Normative theories dominated the 1950s and 1960s. The normative theorists paid their attention to make the accountants know what should be done to get a good outcome (Godfrey et al. 2006). Positive theories were developed during 1970s. The positive theorists paid more attention to describe the behaviors of people, find the reasons for those behaviors and forecast what to be done in the future (Godfrey et al. 2006). Information asymmetry Information asymmetry occurs when some parties have more business information than the other parties in trading.

One type of information asymmetry is adverse selection. It happens because the parties inside the business, such as managers, they could get more information about the business of right now and the future that the outside parties could not obtain. The other type is moral hazard and this happens because some parties could not see the behaviors of the other parties in the transaction (Scott 1997). Moral hazard is the problem of motivate managers to work hard for the owners’ interest and this happens because the owners and the managers of the firm is separated.

The managers may work hard for their own interest rather than that of shareholders, and at the same time, the shareholders of the company could not see what the managers’ behaviors and whether they are working for maximize the wealth of the company (Scott 1997). To solve this moral hazard problem, the accounting net income could be used as a tool to measure how the managers perform. There are two reasons for that: firstly, the managers could work hard to increase the accounting net income in order to increase their remuneration.

Secondly, it could also give chances for outsiders to evaluate the managers’ performance and it will monitor the managers’ behaviors. Fundamental problem of financial accounting theory The investors would against both the moral hazard and adverse selection problems at the same time. The fundamental problem of financial accounting theory arise as the result of control these two problems together and the problem is that how to reconcile the different roles for accounting information.

The relevant information could make the outsiders know the firm’s development plans in the future, and the reliable information could make the investors get the neutral and correct information of the company (Scott 1997). Normative and positive theories There are two major parts of the accounting theories which are normative theories and positive theories. Normative accounting theorist indicated that what the practiced accountants ought to be done to reach the goal (Godfrey et al. 2006). As it provided the guidance for practicing accountants, so they could easily followed this prescribed method to do their practices.

The conceptual framework theory and historical cost accounting are the two major parts of normative theories (Godfrey et al. 2006). Rather than to show the accountants what ought to be done to get a good result, positive theorists paid more attention to describe the behaviors of people, find the reasons for those behaviors and forecast what to be done in the future (Godfrey et al. 2006). As this characteristic of positive theories, the practicing accountants could apply positive theory to obtain a more understandable and reasonable idea to facilitate their exercises.

The positive accounting theory involve two phases, first phase is to investigate the capital market and the second phase is to explicate and forecast the accounting practice relate to the company (Godfrey et al. 2006). Positive accounting theory Positive accounting theory is the theory that aim to explain why financial statements are produced and audited voluntarily, why accountants choose the particular accounting methods over others and why accountants or managers lobby for or against a particular accounting methods (Godfrey et al. 006). It is very important for practicing accountants to understand the positive accounting theory because it is very useful for them. For example, the auditors could aware the managers would choose accounting methods to increase their own interest. Also, it is useful for practicing accountants when making financial decision and advising clients and managers about making financial reporting decisions. As the importance of positive accounting theory for practicing accountants, the following discussion would emphasis on this theory.

The positive accounting theory is based on a view of the firm as a nexus of contracts’ (Scott 1997, p. 9). There are various types of contracts in the firm and positive accounting theory emphasis on two agency contracts which are management compensations and debt contracts (Godfrey et al. 2006). Agency costs Jensen and Meckling (1976, p. 308) define that ‘an agency relationship as arising where is a contract under which one party (the principle) engages another party (the agent) to perform some service on the principal’s behalf’. One example of the agency relationship arises from the owner and the manager of the company.

The owners of the company are the principals and the managers are the agents and the managers the managers to work for the best interest of the company, but some managers might work for maximize the remuneration of themselves as the self-interest and it would be divergent to the interest of the shareholders. The agency costs would arise as a result of this problem. The shareholders would incur the monitor cost to supervise the managers’ performance. The shareholders would incur more costs to supervise the performance for the managers who do not have a good reputation, and accordingly, pay less remuneration for them (Godfrey et al. 006). Moreover, the shareholders would also incur bonding costs in order to make the managers to work for the principals’ interests (Godfrey et al. 2006). Although the shareholders incur these costs to make the managers to work for maximize the value of company, there are still some managers would work for their interests rather than the principals’. The company would suffer the residual loss as a result of the managers pay less effort to increase the firm’s value (Godfrey et al. 2006). Manager-shareholder agency relationships

The shareholders and the managers have the different plans of development of the company. There are some problems to illustrate the reason for that. First of all, the managers would choose the less return but less risky project to invest in order to maximize their human capital. The shareholders of the company would not avoid the risk as they could have different types of investments and their responsibilities to the firm are limited by their shares Therefore they would like to make the manager take the risky projects for the higher return of the company and maximize their interests.

In contrast, the managers would choose the less return but less risky investment in order to maximize their human capital (Godfrey et al. 2006). This is because that if the managers invest in the high risky projects in order to maximize the value of the business, but unluckily this investment makes the company suffer a big loss, the reputation of the managers would be very bad and the shareholders and the outsiders would doubt for their expertise for work. Therefore, to retain the human capital, the managers would not choose the high risky project for the high return of the company.

Secondly, the managers would not like to pay more dividends from the company’s earnings (Godfrey et al. 2006). The shareholders want to get more dividends so that they could use the money to have the other investments in order to maximize their profit. However, the managers want to keep the dividends as the retained earning to develop the business, as the result of the development, their power of the company will be bigger and the company would pay more remuneration to them. Thirdly, the shareholders are interested in long term profit, whereas, the managers are focus on the short term growth of the company.

They intend to increase the company’s profit in short terms, so that their human capital would be increased accordingly. Therefore, they could move to another firm which they could get higher remuneration. The shareholders would use management compensation contract to reduce these agency costs of equity and increase the firm’s value (Godfrey et al. 2006). To motivate managers to work for maximize the value of the company, only pay the fixed salary is not enough. If the managers only receive the fixed salary, they would not pay the additional effort to work for the shareholders’ interests.

Moreover, they would work for maximize their self-interest. Therefore, give the managers bonuses that tied to company’s performance could give the motivation to work for shareholders’ interest. The bonuses could be paid in cash or shares and they could be tied to the accounting numbers such as net income, sales and return on assets or share price (Godfrey et al. 2006). Bonus plan hypothesis As the bonuses are tied to the accounting numbers, managers would have an intention to control the accounts so that they could get more bonuses payment.

Moreover, managers would focus on short-term profit especially for those managers who are approaching retirement. They would choose the accounting method to increase the profit of current period in order to get higher bonuses in short-term (Godfrey et al. 2006). There is another problem that the bonuses tied to share price. Market would affect the share prices and it is impossible for managers to control the market. Moreover, only the very superior managers could have the chance to affect the share price and it would make low-grade managers lack of encouragement to work for shareholders’ interest (Godfrey et al. 006). Shareholder-debtholder agency relationship Godfrey et al. (2006, p. 308) defined that ‘the principal in this instance is the debtholder, or lender; the agent is the manager acting on behalf of the shareholders or other owners’. As the managers act on the interest of shareholders, they would want to increase the value of the company by reduce the debtholders’ interest and they have four ways to do that. First of all, managers would pay more dividends to the shareholders with the intention to decrease the funds to service the debt (Godfrey et al. 006). Secondly, managers would invest the funds in a higher risky project in order to earn the higher return for the shareholders when debt is issued that reflects a particular risk (Godfrey et al. 2006). As the shareholders’ liabilities are limited by their number of shares, so they would choose to invest in a high risky project. Thirdly, underinvestment, it occurs when management or shareholders reject attractive positive NPV investments on the grounds that most of the benefits accrue to debtholders (Godfrey et al. 006). Finally, claim dilution, it makes the original debt riskier and lowers its value to the original debtholders when further debt is issued (Godfrey et al. 2006). As the debtholders know these behaviors, they would reduce the funds that lend to the shareholders or charge more interest to protect their interest. They would add the debt covenants in the debt contracts to restrict the managers’ performance. Debt covenants often rely on the numbers contained in the financial statements.

The restriction of debt covenants would include financing-leverage limits, dividend payment restrictions, financial information requirements, and so on (Godfrey et al. 2006). It would be very costly for the firm if they breach the debt covenants. For example, the lender would ask the shareholders to repay the funds immediately and pay additional interest as penalty. More serious outcome is that the credit rating of the company would be damage (Godfrey et al. 2006). Debt to equity hypothesis

The debt hypothesis forecasts that managers acting on behalf of shareholders will choose accounting methods to increase the profit of current period in order to increase the firm’s leverage (Godfrey et al. 2006). The agency theory supports the debt hypothesis that managers have intention to increase the shareholders’ interest by reduce the debtholders’ interest. It means that managers would choose the accounting method that increase the value of the firm by increase the value of asset and/or equity, or decrease the value of liability (Godfrey et al. 2006). Opportunistic and efficiency perspectives

There are two contracting perspectives on positive accounting theory: opportunistic and efficient perspectives. Opportunistic perspective was taken after the contract is finalized and the agents were predicted to behave opportunistically and choose accounting methods or manipulate accounting numbers with the purpose that maximize their own interest rather than the interest of principle (Godfrey et al. 2006). For example, in bonus scheme hypothesis, managers were predicted to behave opportunistically and choose accounting methods or operate the accounting numbers to maximize the amount of bonuses payment.

Also, in debt contract, managers acting on behalf of shareholders would use the accounting method to avoid breaching the debt covenants and protect the value of shareholders (Godfrey et al. 2006). In contrast, efficient perspective was taken before contracts finalized and the agents were predicted to work for the interest of principals and they believe the higher value of the firm, the greater remuneration they could get (Godfrey et al. 2006). Managers believe that their human capital would be decreased if they choose the accounting methods to increase their own interest rather than that of owners’.

Therefore, managers would choose accounting method to reduce the monitoring cost and maximize the value of the firm in order to get more salaries (Godfrey et al. 2006). Information hypothesis As the stewardship role of accounting relates to both the opportunistic and efficient perspective as the contract terms tend to relate to the reliable accounting numbers rather than unrecognized disclosures, the information role of accounting relates to information perspective of positive accounting theory (Godfrey et al. 2006). In this perspective, managers signal their private information to outside investors financial report decisions.

Managers have a comparative advantage in respect of producing and supplying information about the firm, they would use financial statements to provide the relevant information to outsider to assist in their investment decision making (Godfrey et al. 2006). ‘The information hypothesis is aligned with signalling theory, whereby managers use the accounts to signal expectation and intentions regarding the future’ (Godfrey et al. 2006, p. 315). Managers will try to signal positive expectations to investors through the accounts. For neutral news, managers have motivation to report positive news so that suspicion of poor outcome is removed.

For bad news, managers would avoid to report generally, but they would report the bad news to maintain the reputation in market (Godfrey et al. 2006). Political costs hypothesis Godfrey et al. (2006, p. 317) stated that ‘positive accounting theory also models the political process involving the relationship between the firm and other parties interested in the firm’. Political costs arise because the firm is highly profitable or big size, so that some interest groups would take the political action in order to transfer wealth from the firm.

To avoid the political costs, managers of politically sensitive company would choose accounting method to decrease the reported profit (Godfrey et al. 2006). But these managers may be have conflicting incentives when they choosing accounting methods. In bonus plan hypothesis, the opportunistic managers would choose accounting method to increase the profit of current period. However, their firm is politically sensitive, so they must choose accounting method to decrease the profit of current period and thereby reduce the political costs (Godfrey et al. 2006).

Empirical research into positive accounting theory One of the characters of positive accounting theory is that it could illustrate the reason for the accountants’ behavior. Therefore, it is important to apply empirical test to prove whether this theory could actually explain the reality (Godfrey et al. 2006). For debt to equity hypothesis, the research result supports for debt contract terms impacting on accounting policy. Managers would choose increase asset or income policies when the firms are close to default on debt covenants (Godfrey et al. 2006).

For bonus plan hypothesis, managers with the bonus plans are more likely to choose the accounting method to increase the profit of current period on order to get higher bonuses payments. The results for this hypothesis are mixed and the researchers need to focus on specific contract attributes, but it is difficult to get these (Godfrey et al. 2006). For political hypothesis, the research result tends to support its impact on accounting policy choices. Managers would choose accounting method to decrease firm’s profit in order to reduce the political costs (Godfrey et al. 2006).

In general, the results of empirical research tend to support the debt to equity and political cost hypothesis and provide mixed results in relation to the bonus plan hypothesis, and moreover, the efficiency perspective is supported (Godfrey et al. 2006). Critique of positive accounting theory Positive accounting theories were criticized for their usefulness, methodological and statistical, and philosophical (Godfrey et al. 2006). First of all, positive accounting theory is to illustrate the reason for practicing accountants’ behavior and forecast what to do in the future, but is does not provide a means of improving accounting practice.

Secondly, positive accounting theory asserts it is value free, but in fact it does not. Selection of theory and assume self-interest are value judgements. Thirdly, the theory was lack of development since 1970s. Fourthly, this theory has some scientific shortcomings as the hypotheses of the theory are frequently not supported. Finally, the researchers of positive accounting theory believe they could generate rule and principles that operate in different situation, but the generalizations may not apply to specific situations that exists in individual organizations (Godfrey et al. 006). Usefulness of positive accounting theory Although positive accounting theory has some shortcomings, it provide a framework which is helpful for making financial reporting decisions or audit the other’s decisions. It illustrates some factors to consider when making financial reporting decisions. First of all, the contracts of company, they are not only included management compensation contracts and debt contracts. Secondly, company would want to enter into some contracts in the future.

Thirdly, the assets of the company which may also be an efficient determinant when selecting between particular decision alternatives. Fourthly, managers may signal the private information to outsiders in order to avoid problem associated with adverse selection. Finally, if there are too much good news reported, the company would have some potential political costs. Moreover, the theory is useful for predict the effect of accounting regulation because the effects of introducing an accounting standard can be predicted before the implementation (Godfrey et al. 2006). Conclusion

In conclusion, this essay provided a general assessment of information asymmetry and the fundamental problem of accounting, and it will also briefly discuss the normative and positive accounting theories and their usefulness to practicing accountants. It also critically evaluated the usefulness of positive accounting theory to practicing accountants today. To discuss the usefulness of positive accounting theory, it covered bonus plan hypothesis, debt to equity hypothesis, political cost hypothesis and signalling theory and discuss the impact on the choice of accounting methods and the accounting role related to them.

Moreover, it illustrates some strengthens and the limitations of positive accounting theory. LIST OF REFERENCE E. Hendriksen, Accounting Theory (Illinois: Richard D. Irwin, 1970), p. 1 Godfrey, J. , Hodgson, A. , Holmes, S. & Tarca, A. 2006, Accounting theory, 6th edn. , John Wiley & Sons, Brisbane, Queensland. M. Jensen and W. Meckling, ‘Theory of the firm: Managerial behavior, agency costs and ownership structure’, Journal of Financial Economics, vol. 3, October 1976, pp. 305-60. Scott, WR 1997, Financial accounting theory, International edn, Prentice Hall, Englewood Cliffs, New Jersey, pp. 1-11.

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