Accounting Theories:to fulfill the qualitative characteristics of relevance and reliability,

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Accounting Theories

Accounting Theories

 Decision Usefulness theory

  • Financial statements play an utmost important role to variety of users, which mainly consist of investors, lenders, suppliers and other trade creditors, customers, governments and as well as the public.
  • For the accounting information to be ‘decision useful’ to these groups, the selected financial information has to fulfill the qualitative characteristics of relevance and reliability, while the subsequent presentation of the financial information should be both understandable and comparable (Henderson et al, 2006).

 Signaling Theory

  • The idea that one party (mostly managers) conveys some meaningful information about itself to another party (the shareholders or outside parties).
  • Is based on the assumption that information is not equally available to all parties at the same time, and that, information asymmetry is the rule.

Positive Accounting Theory (Watts and Zimmerman, 1986)

  • Is concerned with explanation and prediction of accounting practice for example it seeks to explain why firms use historical costing and why certain firms switch between a numbers of accounting techniques.
  • Predicts the choices that management will make regarding their choice of accounting policies.
  • Is linked to earnings management because it explains manager’s choices in accounting methods in terms of self interest (Bonus plan hypothesis).
  • Based on 3 hypothesis- bonus plan, debt covenant and political cost.

Bonus plan hypothesis dictates that managers will use accounting policies that are likely to shift reported earnings from future periods to the current period. This is to maximise their personal compensation as by reporting a high net value will help them achieve their bonuses and incentives.

Debt covenant hypothesis states that closer a firm is to comprising their debt covenant, the more likely management is to use accounting policies that shift reported earnings from future periods to the current period. This is because higher net earnings will reduce the probability of technical default on the debts. It also predicts that the higher the firms debt/equity ratio, the more likely managers will use accounting methods that increase income.

Political cost/size hypothesis predicts that large firms rather than small firms are more likely to use accounting choices that reduce reported profits. The greater the political costs faced by a firm, the more likely the manager will chose accounting procedures that defer reported earnings from current to future periods.

Regulatory Theories

Public Interest Theory

  • According to Posner (1974), this theory holds that regulation is supplied in response to the demand of the public for the correction of inefficient or inequitable market practices.
  • Regulation is costless

Private Interest Theory

  • Assumes that groups will form to protect particular economic interests. Different groups are viewed as often being in conflict with each other and the different groups will lobby government for price protection or producers might lobby for tariff protection.
  • Adopts no notion of public interest theory but rather considered to dominate the legislative process.

Bushfire Theory

  • Highlights the political and public nature of regulatory influences by attempting to take into account the reactions of users and society in general, to failures of regulatory processes.
  • Regulations tend to arise from crises such as the collapse of Enron, WorldCom and HIH.


Capture Theory

  • The regulated parties seek to take charge of (capture) the regulator so that the rules that are subsequently released (post-capture) will be advantageous to the parties subject to the requirements of the rules.
  • Power of government can be used to give valuable benefits to particular groups, such as accounting industry.
  • Regulation can be viewed as a product that it governed by the laws of supply and demand meaning that the attention is focused on the value and cost of regulation to particular groups.


Agency Theory


  • A theory explaining the relationship between principals (shareholders) and agents (managers). In this relationship, the principal delegates or hires an agent to perform work in the best interest of the principal.
  • There are three main agency problems. They are risk aversion, dividend retention and horizon disparity.
  • Agency costs: Monitoring, bonding and residual cost.
  • Moral sensitivity is an alternative to bonus incentives and would reduce agency problems. (Steven and Thevaranjan, 2009).
  • Directors remuneration package consists of bonus incentives which would motivate managers to engage is some sort of earnings management in order to achieve those bonuses linked to accounting earnings i.e. profits, dividends etc.
  • Can be easily connected to PAT and its bonus plan hypothesis.



Systems-Oriented Theory


Legitimacy Theory

  • Proposes that organisations would always have to ensure that they operate within the bounds and norms of their societies. It is assumed that the society allows the organisation to continue its operations as long as it generally meets society’s expectations.
  • It assumes a social contract between the society and the organisation, using the annual report as a tool in which management can demonstrate its fulfillment of its obligations to meet community concerns and values.

 Stakeholder Theory

  • Emphasises the ethical responsibilities of organisations to their stakeholders, and in particular, the need for management of relationships with smaller, more powerful stakeholder groups.
  • It has both an ethical (normative) and managerial (positive) branch.
  • Ethical branch adopts that all stakeholders have certain rights and these rights should not be violated.
  • Managerial branch emphasises the need to manage particular stakeholder groups, especially powerful ones. Some stakeholders are powerful because they control resources needed by the organisation’s operations and for its survival e.g. regulators, suppliers and consumers are powerful for this reason.

Accountability Theory

 Involves the control and regulation of relationship between a corporation and its stakeholders, whether shareholders or a wider community, mediated through the disclosures made by the company.

  • Involves the monitoring, evaluation and control of organizational agents to ensure that they behave in the interests of shareholders and other stakeholders. (Keasey and Wright, 1993).

 Institutional Theory

 Considers the forms organisations assume and explains why organisations within a particular ‘organisational fields’ tend to take on similar characteristics and forms.

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