CHAPTER 5

Theories in accounting 
LEA RN IN G OBJE CTIVE S

After studying this chapter, you should be able to:

5.1 evaluate how theories can enhance our understanding of accounting practice
5.2 integrate knowledge about positive accounting theory and agency theory and apply them to agency
contracts between owners, managers and lenders to explain accounting practice and disclosure
5.3 evaluate institutional theory in terms of its application to organisational structures and apply the theory
to accounting practice and disclosure
5.4 evaluate legitimacy theory and the notion of the social contract and apply it to accounting practice and
disclosure
5.5 evaluate stakeholder theory and apply it to accounting disclosure
5.6 evaluate contingency theory in terms of its application to accounting practice and disclosure
5.7 reflect on the different decisions made by accounting practitioners, evaluate and justify how theories
can be used to explain a range of decisions.
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Rankin, Michaela. Contemporary Issues in Accounting, 2nd Edition, Wiley, 2017. ProQuest Ebook Central, [Link]
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 Real world
practice

Assist us to explain and

understand real world practice

Theories

Positive theories —
Normative theories —
describe, explain and predict
prescribe best practice
accounting practice

Positive
Contingency Institutional Legitimacy Stakeholder
accounting
theory theory theory theory
theory

Assist us to explain,
Accounting practice
understand and improve
and decision making
accounting decisions
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 To understand the range of decisions that an accountant is required to make, how accounting systems are
integrated into an organisation, and demands for accounting information, it is useful to investigate theories
which can assist us in these endeavours. In this chapter we start by exploring what role theory can play in
understanding or explaining accounting practice. We also categorise theories as being normative or positive.
We start by explaining these types of theories and introduce some theories that are currently used to either
explain or understand accounting decision making and practice (positive theories) or propose recommended
courses of actions for entities (normative theories). Throughout the investigation of these different types of
theories, examples of how they have been used will be provided. Finally, how these theories can help to
understand accounting decisions from the perspective of preparers of accounting information is examined.

5.1 What value does theory offer?

LEARNING OBJECTIVE 5.1 Evaluate how theories can enhance our understanding of accounting
practice.
Theories are constantly used in the world around us. Builders, engineers and architects rely on structural
engineering and mathematical theories in building design and development. Structural theories are based
on physical laws and research which explain the structural performance of materials. We observe the
outcomes of these theories in the construction of buildings, roads, tunnels and bridges. Governments
use monetary and economic theories to formulate and cost policies or when setting taxes. These theories
relate to the effect of expenditure or taxes on inflation and the national debt, as well as social justice
considerations such as unemployment.
The Reserve Bank of Australia also relies on economic theories to construct monetary policy for the
financial system. We see the result of economic theories when the Reserve Bank changes interest rates;
we then observe the impact this has on spending and inflation.
Similarly, theories in accounting can help us to understand the decisions of financial information
preparers, as well as users of the output of the accounting system, including shareholders, lenders, inves-
tors and employees. Despite popular opinion, accounting involves much more than recording financial
transactions according to a set of rules or standards. Accounting is an activity that requires accountants
to make decisions on what information to provide, how accounting methods are going to be applied, and
the extent of information to disclose to users. Accounting is a human activity, and while we can never
fully know what motivates people to make the decisions they do, theories can be useful in helping us to
understand and explain what might have influenced the decision‐making process.
Theories that examine the operation of capital markets explain how share prices change when accounting
information is provided to the market. This knowledge allows us to understand how investors make decisions
based on accounting information. Other theories explain and predict managerial choice of accounting
methods and how they relate to remuneration contracts and lending agreements. Further, theories can explain
voluntary disclosure of information to satisfy stakeholder needs or societal expectations. These theories are
particularly relevant in understanding why managers present information voluntarily about environmental or
social performance, or about financial activities beyond that required by accounting standards.
Theories can also assist us to understand how organisational systems and controls are contingent on
both external or environmental and internal or entity‐specific factors that affect the organisation. Rather
than explaining actions, other accounting theories can assist in determining what appropriate methods
should be used or how accounting information should be measured and reported. These theories are
designed to provide solutions or improvements.
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Types of theories
There are two main types of theories used in accounting:
•• normative theories
•• positive theories.
This chapter discusses each of these in more detail.

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 Normative theories
Normative theories provide recommendations about what should happen. They prescribe what ought to be
the case based on a specific goal or objective. The outcome of a normative theory is derived through log-
ical development and based upon a stated objective. The Conceptual Framework for Financial Reporting
(Conceptual Framework) is one example of a normative theory. With the objective of financial reporting
stated in the Conceptual Framework as its foundation, a range of prescriptions are made about who should
report; what qualities financial information should have; how the financial statement elements, such as
assets and liabilities, should be defined; when the information should be recognised within the accounting
reports; and how information should be presented to be meaningful.
A normative theory is not necessarily based on what is happening in the world, but on what should
be the case given the objective upon which it is based. That does not mean that the development of nor-
mative theories is completely divorced from reality. Often normative theories evolve from observations
and research into practice, undertaken using positive theories.
Positive theories
A positive theory describes, explains or predicts activities. For example, a positive theory could explain
why managers choose particular accounting methods in situations where accounting standards allow such
choice, and predict what other organisations might do when faced with similar circumstances. Positive
theories can help us to understand what is happening in the world, and why organisations act the way they
do. As such they rely on real world observations. Positive theories can help us to understand the decisions
users make with regards to accounting information, and this can then lead organisations to make more
informed decisions about how and why they present information the way they do.
We will now examine a range of theories commonly used in the accounting and disclosure fields to
understand accounting activities. These theories include positive accounting theory, institutional theory,
legitimacy theory, stakeholder theory and contingency theory. While most of these theories are positive
theories, some also have normative underpinnings.

5.2 Positive accounting theory

LEARNING OBJECTIVE 5.2 Integrate knowledge about positive accounting theory and agency theory
and apply them to agency contracts between owners, managers and lenders to explain accounting
practice and disclosure.
As the name suggests, positive accounting theory is a positive theory used to explain and predict
accounting practice. It is ‘designed to explain and predict which firms will and which firms will not use
a particular method’.1 The theory is used when we attempt to understand accounting policy decisions,
including responses to new accounting standards or voluntary disclosure decisions. For example, posi-
tive accounting theory could predict which managers, and entities, will react favourably to the require-
ment to record financial instruments at fair value, and which might be opposed; or which are likely to
disclose additional information about the risks associated with the use of derivative financial instruments
before being required to do so in accordance with accounting standards.
Positive accounting theory examines a range of relationships, or contracts, in place between the entity
and suppliers of equity capital (owners), managerial labour (management) and debt capital (lenders or
debt holders). It is based on an underlying economic assumption called the ‘rational economic person’
assumption, which assumes that all individuals act to maximise their own utility.2 That is, they act in
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their own self‐interest. This assumption is drawn from rational choice theory.3 Rationality is a concept
that is explored extensively in economics, but there is no clear indication what it means. While some
see rationality as maximising financial rewards, others take a broader view of utility beyond maximising
wealth. While a further exploration of this concept is beyond the scope of this book, it is important to
understand what ‘version’ or rationality is assumed by positive accounting theory. The theory takes the
view that maximising utility relates to maximising financial wealth, with non‐financial aspects of utility

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 functions being ignored.4 As a consequence, the theory is likely to have limited value when considering
activities that might be considered altruistic.
Positive accounting theory is derived from a number of economic theories including contracting
theory and agency theory. We will consider each of these in turn.

Contracting theory
Contracting theory suggests that the organisation is characterised as a legal ‘nexus of contracts’ or as
the centre of contractual relationships, with contracting parties having rights and responsibilities under
these contracts.5 It is argued that an organisation is an efficient way of organising economic activity6 and
firms are organised in the most efficient way so as to maximise their chance of survival.7 The parties to
these contracts include shareholders, lenders, managers, employees, suppliers and customers.8 While an
entity can facilitate this wide array of contractual relationships, positive accounting theory focuses on two:
managerial contracts and debt contracts. With the separation of ownership and control in modern organi-
sations, managers are appointed by owners on contracts that outline the details of their role and how they
will be remunerated for undertaking that role. Managers also contract with lenders on behalf of owners to
obtain debt funding. Both managerial and debt contracts are used to manage these agency relationships.

Agency theory
Agency theory is used to understand relationships whereby a person or group of persons (the principal)
employs the services of another (the agent) to perform some activity on their behalf. In doing so the
principal delegates the decision‐making authority to the agent. This is generally known as an agency
relationship.
While the agent has a legal and fiduciary duty to act in the best interests of the principal, the assump-
tion that both parties are utility maximisers means that the agent will not always act in the interests of
the principal, if this does not coincide with their own interests.9 The risk that managers might undertake
actions that are detrimental to owners or other principals is often termed moral hazard. If the interests
of the agent and principal are not aligned, then the manager could make decisions that are not in the best
interests of the principal. Jensen and Meckling identified three costs associated with having to rely on an
agent to make decisions and conduct the business, referred to as agency costs: monitoring costs, bonding
costs and residual loss.10

Monitoring costs
The principal incurs monitoring costs in order to measure, observe and control the agent’s behaviour.
These might include costs to have the financial reports audited, to put in place operating rules or set up
a management compensation plan, which outlines what the manager (agent) is paid for the service they
provide. While these costs are initially incurred by the principal, the principal will pass these costs on
to the agent. These costs are likely to be higher for an agent with a poor reputation than for one with a
good reputation. For example, in the relationship between owners and managers, owners as principals
who are worried about a manager’s performance will put more stringent monitoring systems in place,
such as an audit committee, and will pass these costs on to the manager through reduced remuneration.
Where a debt contract is concerned, lenders are concerned about the financial performance of companies
they lend to and how this might affect the risk involved in lending. The greater the risk anticipated, the
more lenders would want to monitor financial performance of firms they lend to. Lenders, as principals
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will also use auditing to monitor managers (who are considered agents acting on behalf of shareholders).
Lenders are likely to increase interest rates charged on loans, or lend for a shorter period if they are
required to undertake more monitoring of the entity. This means as the costs of monitoring an agent’s
behaviour increase, the remuneration paid to those agents will decrease or the cost of borrowings will
increase. This is known as price protection. While principals initially bear the costs of monitoring,
these costs are actually passed on to the agent.

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 Bonding costs
Because price protection means agents will actually bear the costs of monitoring, through such mech-
anisms as lower remuneration or higher interest rates, managers (the agents in both of these contracts)
are likely to provide some assurance that they are making decisions in the best interest of the princi-
pals. One example might be incurring the time and effort involved in producing and providing quarterly
accounting reports to lenders. Managers might also agree to not provide information to some external
parties who may gain a competitive advantage from it.11 These activities are known as bonding costs.
They will cost the manager through extra time and effort or income the manager has to forgo as a result
of not providing information externally.
Residual loss
Despite these controls, it is too costly to guarantee an agent will make decisions optimal to the principal
at all times and in all circumstances. At times it might cost more to monitor agents than the expected
benefits from that monitoring. For instance, it might be too costly to monitor the use of a manager’s
travel expenses to ensure they are only for business purposes, or his or her use of business stationery for
personal use. This additional divergence is referred to as residual loss.
The majority of monitoring and bonding costs are going to be borne by agents through reduced remu-
neration (in a managerial contract) or higher interest rates (in a debt contract). Because of this, managers
have incentives to minimise these costs. However, principals are never going to perfectly estimate the
full impact of the agent’s behaviour. Agents know this and perceive that they will not be fully penalised
for all their behaviour that is not in the interests of principals. Because of this, residual loss is borne by
both the principal and the agent.12
Accounting plays a large role in monitoring and bonding mechanisms. Accounting information is
used to design the contracts to bond agents’ behaviour as well as to monitor performance against those
contracts. As such, agency theory relies heavily on the accounting function. We will now discuss how
accounting plays a role in both owner–manager relationships and manager–lender relationships.

Owner–manager agency relationships

As previously mentioned, separation of ownership and control means that managers, as agents, are likely
to act in their own interest and these actions might not necessarily align with the principal’s or owners’
interests. One example could be the manager using entity resources, including stationery, office facilities,
the company car and time during business hours running their own business ‘on the side’. Owners bear the
costs of this behaviour. The agency theory literature identifies a number of problems that can exist between
managers and owners in an agency relationship. It also suggests how contracts and accounting information
can be used to ‘monitor’ managers and ‘bond’ the interests of owners and managers to reduce these prob-
lems. These problems include: the horizon problem, risk aversion and dividend retention.13
Horizon problem
Managers and owners (shareholders) tend to have differing time horizons in relation to the entity. This
is known as the horizon problem. Shareholders have an interest in the long‐term growth and value of
the entity. The share value of the entity today reflects both accounting earnings and the present value of
expected future cash flows. Consequently, owners want managers to make decisions that enhance not
only current earnings, but also the future cash flows of the entity over the long term. Managers, on the
other hand, are interested in the performance and cash flow potential only as long as they expect to be
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employed by the entity. This is particularly a problem for managers who are approaching retirement.
Managers who are seeking to move to another entity within the short term are more likely to wish to
demonstrate the short‐term profitability of the entity as evidence of effective management. Doing so is
likely to enhance the remuneration they can command in the new position.
Managers can demonstrate short‐term profitability in a number of different ways. They could, for
example, delay undertaking maintenance or upgrades to equipment or plant, or reduce research and

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 development expenditure. While increasing short‐term profitability, these activities can have adverse
consequences for longer‐term costs relating to future productivity of the entity.
This problem can be reduced by linking management rewards to the longer term performance of the
entity. This occurs through the managerial remuneration contract. Linking managerial bonuses to share
price, or paying a proportion of managerial remuneration as shares or share options encourages man-
agers to focus on long‐term performance because it is likely to affect their own wealth. This will move
the manager’s focus from short‐term profitability to longer term activities designed to improve future
cash flows, and therefore share price. Tying a greater proportion of managerial pay to share price move-
ments as the manager approaches retirement is also likely to encourage managers to maximise long‐
term performance. As share price reflects the present value of future cash flows, in addition to earnings
potential, this will encourage managers to focus on activities that will increase these metrics.
Risk aversion
Managers generally prefer less risk than shareholders. Shareholders are not likely to hold all their
resources as shares in only one entity. They are able to diversify their risk though investing across mul-
tiple entities, cash or property investments. Shareholders may also receive regular income from other
sources, for example a personal salary. In addition, shareholders’ liability is limited to the amount they
are required to pay for their shares, so they will not suffer losses beyond the amount which they have
paid for their shares. This means they have ‘hedged’ or minimised the risk of one of these investments
losing value. Managers, on the other hand, have more capital invested in the entity than shareholders
through their ‘human capital’ or managerial expertise. They can only diversify their risk to a small
extent by investing in other entities or property, for instance. However, their most valuable asset — their
expertise — cannot be diversified. It is likely that their remuneration from this management role is
their primary source of income. As such, losing their job or being paid less can substantially affect their
personal wealth.
Economic theory proposes that higher risk has the potential to lead to higher returns. Shareholders,
therefore, prefer that managers invest in higher‐risk projects, which are likely to increase the value of the
business. Managers meanwhile wish to take less risk when deciding on projects for the entity because
they have more to lose. Managers are more risk averse than shareholders.
To reduce the agency costs associated with risk aversion, managerial remuneration contracts can
include incentives to encourage managers to invest in more risky projects. For instance, providing man-
agers with a bonus that is linked partly to profits, in addition to a cash salary, can encourage managers to
consider more risky projects that have the potential to increase profits and, as a consequence, managerial
pay. Similarly, paying a bonus based on share price will encourage managers to have a longer term focus
aimed at maximising share price, rather than a short‐term focus on profits. This is likely to encourage
investment in positive NPV projects and lead to increased firm value and consequently share price.
However, it is important to ensure managers are not disadvantaged through too high a focus on shares
in their remuneration for two reasons. First, share price is affected by a range of market and industry
factors out of the manager’s control. This is discussed in more detail in the chapter that looks at earnings
management. Second, increasing managerial share ownership increases a manager’s risk aversion as it
further decreases a manager’s ability to diversify risk. A manager is tied to the entity through not only a
human capital investment but also a share investment. Therefore, managers should be remunerated with
a mix of cash and shares, focusing on both short‐term profits and longer term share values. Limiting the
share‐based compensation as a manager’s ownership in the company increases is likely to encourage
managers to invest in more risky opportunities.
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Dividend retention
Managers, when compared to shareholders, prefer to maintain a greater level of funds within the entity,
and pay less of the entity’s earnings to shareholders as dividends. This is known as the dividend
retention problem. Managers wish to retain resources within the business to expand the size of the
business they control (empire building), to pay their own salaries and benefits. Shareholders, on the

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 other hand, wish to maximise the return on their own investment through increased dividends. This is
especially the case if shareholders feel they can get a higher return from investing these dividends than
the returns that might be available to the entity.
Paying a bonus that is linked to a dividend payout ratio will likely encourage managers to enhance
dividend payouts to shareholders. Similarly, linking bonuses to profits will also encourage managers to
seek additional profits, which in turn are likely to be available for dividends.
Profits, and increasingly shares and options, are commonly used as a basis for executive remuneration
contracts worldwide. The performance criteria used in executive contracts employ a range of accounting
measures. Contemporary issue 5.1 discusses how News Corp used a range of incentive mechanisms to
align managers’ interests with shareholders.

5.1 CONTEMPORARY ISSUE

News Corp reduces agency problems through executive

remuneration plans
News Corp has been heavily criticised by investors and fund managers for both large bonuses paid to exec-
utives, and its focus on short‐term performance. The company recently restructured its executive remuner-
ation scheme to tie executive remuneration more closely to News Corp’s share price performance.
The scheme gives Rupert Murdoch, the chairman, chief executive and largest shareholder, the
chance to earn an annual cash bonus of up to US$25 million. James Murdoch’s potential bonus range
is US$6 million to US$12 million. Chase Carey, deputy chairman and chief operating officer, could earn
a bonus of between US$10 million and US$20 million a year if the company meets a range of perfor-
mance targets.
While News Corp’s previous bonus scheme awarded cash based on earning per share (EPS) growth,
now two‐thirds of the annual bonuses awarded to the top executives is based on three measures:
EPS growth, which accounts for 40% of the performance target, free cash flow growth (40%) and total
shareholder return (20%). The final third is based on qualitative factors, which include meeting both
financial and non‐financial objectives.
Using a range of performance measures has been seen as a good move by financial analysts, bringing
the company in line with other companies.
Source: Adapted from Neil Shoebridge, ‘News resets top executive pay’, The Australian Financial Review.14

QUESTIONS
1. Both the horizon problem and risk aversion are agency problems that relate specifically to the relationship
between owners and managers and which contracting can assist in overcoming. Explain these two
problems.
2. News Corp Ltd has recently introduced a new pay scheme to link executive pay to a range of performance
measures, including share performance through ‘total shareholder return’. How does linking bonuses to
share performance reduce the horizon problem and risk aversion?
3. Why is it important to link executive bonuses to a range of entity performance measures rather than one,
as was previously the case with News Corp?

Compensation policy is argued to be one of the most important factors in organisational success.15
Not only does the theory suggest it influences how top executives behave, but it also impacts on what
kind of executives an organisation attracts.16
The most recent research has focused on the extent to which executive entitlements are linked to
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entity performance and ultimately shareholder value.17 Results are mixed, with a number of studies
finding either no or an extremely weak relationship between pay and performance. Weak relationships
between entity performance and compensation tend to be more evident where the compensation measure
used is cash only.18
Matolcsy and Wright proposed that it may not be efficient for all types of entities to award equity‐
based compensation to CEOs. They asserted that if compensation structures are set efficiently, based on

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 the underlying economic characteristics of the entity, then entity performance will be maximised.19 For
some entities this may entail the use of cash‐only compensation. The authors divided their sample into
two groups based on contract type: entities who provide only cash compensation to the CEO and those
who have equity‐based compensation schemes in place.
Rankin examines the level and structure of pay across the executive team in Australian listed entities
between 2006 and 2009.20 While the CEO has the ultimate responsibility for the performance of the
firm, many decisions are delegated to lower level managers.21 Delegation of decision making affects
the traditional principal–agent relationship. While lower level managers make decisions on behalf of
owners, those owners are not able to monitor their activities. In addition to the board of directors, the
CEO is in the position to monitor lower level executives; thus researchers have found that the benefits of
incentive compensation as a method to align managerial and ownership interests for managers other than
the CEO are potentially lessened.22 Therefore, you might expect a smaller reliance on incentive compen-
sation in the remuneration packages of non‐CEO executives when compared to CEOs.23
Results of Rankin’s study indicate a variation in both the level and structure of compensation across
the executive team. CEO pay varies across industries, with finance entities paying higher levels of salary,
although salary as a proportion of total pay is lower than other sectors. Researchers in other countries
have found slightly different results. While Ryan and Wiggins found a significant difference between the
level of CEO compensation and that of lower ranking executives in the United States, they found the
structure of pay across the executive team to be consistent.24 Conyon and Sadler saw a greater alignment
between pay and performance as executives moved up the hierarchy of the company in UK firms.25
Executives at the top of the organisational structure had greater ability to affect firm performance.
When Rankin examined CEO pay in Australian firms, cash payments to CEOs — salary and bonus —
were found to be higher in 2009 (following the global financial crisis) than for other years, which is
likely to indicate a shift towards less risky cash rewards from risky equity payments in periods of econ-
omic downturn. The finance sector is more likely to rely on bonuses than other sectors, with mining
entity bonuses constituting a significantly smaller proportion of total pay than other industries.26 Walker
also explored CEO remuneration level and structure for Australian entities and, in particular, focused
on the difference in remuneration between high‐growth firms, such as those operating in computer soft-
ware and biotechnology sectors, and low‐growth manufacturing firms.27 Walker found that high‐growth
entities pay their CEOs a greater proportion of performance‐based pay and place a greater reliance on
market and/or non‐financial performance targets when awarding performance‐based pay.
Given research has found varying results when examining the link between performance and exec-
utive compensation, a number of studies have sought to look further at alternative factors that can be
used to explain the level and structure of executive pay. Research has documented, overwhelmingly,
that compensation levels increase with the size and complexity of the firm, recognising the increased
skill and quality of labour required to lead a large complex organisation.28 There is some evidence that
characteristics of the CEO also determine compensation; as CEO tenure increases, their ability to influ-
ence remuneration also increases and the CEO holds greater levels of expertise. This results in higher
pay levels29 and greater reliance on cash‐based, as opposed to incentive‐based pay30 because CEOs are
more able to influence the board in pay negotiations and therefore the pay–performance association is
more likely to be decoupled.

Manager–lender agency relationships

When a lender agrees to provide funds to an entity there is the risk that the borrower may not repay
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those funds. Agency theory has also been used to understand the relationship between lenders and
management, who act on behalf of the entity and its owners in contracts with lenders. In this situation
the lender is the principal and the manager is agent, who is acting on behalf of the owners. In this
instance the manager’s interests are completely aligned with owners. The agency problems that could
arise include: excessive dividend payments to owners, underinvestment, asset substitution and claim
dilution.31

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 Excessive dividend payments
When lending funds, lenders price the debt to take into account an assumed level of dividend payout. If man-
agers issue a higher level of dividends, or excessive dividend payments, then this could lead to a reduction
of the asset base securing the debt or leave insufficient funds within the entity to service the debt.
To avoid higher interest costs being imposed by lenders or the availability of limited funds (price
protection), managers have incentives to show they are acting in a way that is not detrimental to lenders.
Debt contracts contain restrictions, known as debt covenants, which are designed to protect the interest
of lenders. As a result of agreeing to the terms of these covenants, managers are able to borrow funds
at lower rates of interest, to borrow higher levels of funds or to borrow for longer periods. Accounting
data usually form the basis of these covenants. To reduce the dividend retention problem managers
and lenders agree to covenants that restrain dividend policy and restrict dividend payouts as a function
of profits. Dividend payout ratios are a common covenant in Australian debt contracts. Maintaining
working capital ratios also alleviates excessive dividend payments.
Underinvestment
Underinvestment as an agency problem arises when managers, on behalf of owners, have incentives
not to undertake positive net present value (NPV) projects if the projects would lead to increased funds
being available to lenders. Managers are generally only going to engage in underinvestment when the
entity is in financial distress and facing insolvency. Creditors rank above owners in order of payments in
the event an entity liquidates and any funds from positive NPV projects would go towards the lender, not
owners. Therefore, while shareholders (and managers as agents) will not want to invest in positive NPV
projects when they are in financial difficulty, lenders will prefer these investments because any income
that is derived will go to lenders in the event of liquidation. Covenants that specify the investment oppor-
tunities the organisation is able to use funds for are likely to alleviate this problem. Working capital
ratios will also assist by requiring managers to retain enough current assets in the business to pay current
liabilities, so are more likely to use any excess to invest in projects that will provide a return to lenders.
Asset substitution
As we saw previously, shareholders have diversified portfolios and limited liability, and are happy for an
entity to invest in risky projects. Shareholders benefit from any excessive gains from such projects. Lenders,
on the other hand, determine the interest rate and term of the loan in accordance with the risk level of the
asset or project the entity is borrowing funds to invest in. They lend these funds on the assumption that man-
agers will not invest in assets or projects of a higher risk level than agreed. Because managers are working
on behalf of owners and are often owners themselves, they have incentives to use the debt finance to invest
in alternative, higher‐risk assets in the likelihood that it will lead to higher returns to shareholders. Lenders
bear the risk of this strategy as they are subject to the ‘downside’ risk, but do not share in any ‘upside’ return
resulting from the investment decision because they receive a set rate of interest.
To limit asset substitution debt contracts will often restrict the investment opportunities of the entity,
including merger activity. The lender might also secure the debt against specific assets. Debt to tangible
assets ratios can also restrict asset substitution.
Claim dilution
When entities take on debt of a higher priority than that on issue it is referred to as claim dilution. While
taking on additional debt increases funds available to the entity, it decreases the security to lenders,
making the lending more risky. The most common method of avoiding claim dilution is to restrict the
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borrowing of higher priority debt, or debt with an earlier maturity date.

Research examining debt contracting often runs into difficulty accessing data, because for the most
part, private lending agreements are generally kept confidential. Smith and Warner provided one of the
first studies to document covenant use in public debt contracts in the United States.32 In this research,
the authors had to rely on standard covenant forms that gave an indication of the types of covenants in
use, rather than actual debt agreements. The most common covenants included gearing ratios, merger

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 restrictions, asset disposal restrictions and dividend restrictions.33 Duke and Hunt confirmed these
results when they examined a sample of mainly public debt contracts.34 They found dividend restric-
tions, working capital, current ratio and gearing restrictions to be prevalent. In Australia, Whittred and
Zimmer noted the use of four main types of covenants in Australian publicly listed securities: liabilities
to total tangible assets, secured liabilities to total tangible assets, prior charges to total tangible assets
and interest coverage ratios.35
There has been a decline in the use of accounting‐based covenants over time in public debt agree-
ments.36 In a comprehensive survey of public debt issues in US industrial companies from 1980 to 2006,
Nikolaev found the increased importance of non‐accounting covenants, including managerial behaviour,
while accounting covenants included asset disposal and merger and acquisition restrictions, dividend
restrictions, minimum net worth, leverage, net earnings and minimum ratio of earnings to fixed charges.37
In a study of Australian bank private debt contracts, Cotter found that lending agreements most com-
monly contain leverage covenants, with leverage measured as the ratio of total liabilities to total tangible
assets.38 Contracts also include interest coverage and current ratio constraints. Mather and Peirson con-
ducted a more recent review of both public and private debt covenants.39 In public debt agreements, while
leverage covenants are used (nearly half had restrictions on liabilities), so too are interest cover and divi-
dend coverage ratios. The authors found that interest coverage covenants are commonly used in private
debt contracts (78% of their sample). As with public covenants, most private debt contracts have some
restriction on liabilities with maximum total liabilities / total tangible assets and secured liabilities / total
tangible assets being the most common. Private debt contracts also commonly include covenants requiring
minimum current ratios as well as a minimum net worth. In the United States, Dichev and Skinner found
the most common covenants to be interest cover, fixed charge cover, debt service cover, minimum tangible
net worth and current ratio restrictions.40 Recent research reports debt to earnings before interest, tax,
depreciation and amortisation (EBITDA), and debt to cash flows to be prevalent restrictions in US loans.41
Many accounting‐based covenants rely on balance sheet measures such as debt, total tangible assets
and fixed assets. Parties to these contracts rely heavily on a conservative balance sheet, which has high
levels of verifiability.42 However, the broader adoption of fair value in accounting standards globally
has increased the use of estimates for asset and liability values and discretion in the timing of value
changes.43 As a result, Demerjian observed a decline in the use of covenants that rely on balance sheet
data. However, the use of income statement–based covenants has not declined.44

Role of accounting information in reducing agency problems

Shivakumar proposes that the major role of reported accounting information is in its use for contracting
purposes.45 The primary economic role of accounting information in financial reports cannot be about
providing timely new information to investors because this information is generally available else-
where.46 As previously discussed, accounting information forms one of the major components of both
remuneration and lending contracts. Accounting information plays two roles in the contracting process:
1. to write the terms of managerial contracts.
2. to determine performance against the terms of the contracts.
A contract will generally include clearly stipulated financial accounting measures to define the bound-
aries of an agent’s authority.47
Terms are written into managerial remuneration contracts to link managers’ performance to share-
holder interests. In addition to a base salary, compensation can comprise a mix of short‐term and long‐
term bonuses. Bonuses can be tied to measures of entity financial performance or share performance. It
Copyright © 2017. Wiley. All rights reserved.

could be argued that share prices would be a valuable performance measure in order to alleviate agency
problems between shareholders and managers, given the wealth of shareholders depends directly on
traded share prices and they are less susceptible to manipulation.48 Further, and as previously indicated,
compensating managers on share prices also allows managerial incentives to be aligned over a longer
term. However, relying totally on share prices disadvantages managers when the shares are closely held
or share prices are affected by industry or market factors that they cannot control.49

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 Accounting information plays a number of roles in debt contracting. At the inception of the con-
tract, financial statements give key information to the lender to assist in determining the parameters,
or terms of the contract. When a debt contract is written it will include covenants to either restrict the
borrowing firm’s activities (restrictive covenants) or to require the firm to carry out certain activities
(affirmative covenants).50 For example, restrictive covenants could relate to restricting dividend pay-
ments, or undertaking further borrowings, while, affirmative covenants could include requiring quarterly
audited financial statements. Covenants often reflect different measures of entity performance, such as
leverage, working capital, dividend payout or interest coverage ratios. Lenders will look to regular finan-
cial updates to confirm borrowers are maintaining the terms of their covenants.

Information asymmetry
In addition to accounting information being used as part of contracting process, it is also commonly
provided in order to reduce information asymmetry. Information asymmetry results from managers
having an advantage over investors and other interested parties as they have more information about
the  current and future prospects of the entity, and can choose when and how to disseminate this
information.
Managers can use accounting disclosure, as well as other forms of disclosure and announcements to
the market, to signal expectations about the future. These signals could portray either good or bad news.
Verrecchia takes the view that unless the information would give competitors an advantage if they knew
it, managers have incentives to disclose both good and bad news.51 If entities did not provide informa-
tion when other entities in the market did so, it would be assumed they had bad news to report and their
share price would suffer as a result. This is often referred to as adverse selection. In this instance it is
in the entity’s best interest to provide news — good or bad — to the market so as to avoid being seen as
a poor investment.

5.3 Institutional theory

LEARNING OBJECTIVE 5.3 Evaluate institutional theory in terms of its application to organisational
structures and apply the theory to accounting practice and disclosure.
Institutional theory has been used extensively in management literature, and is increasingly used in
accounting research to understand the influences on organisational structures. It considers how rules,
norms and routines become established as authoritative guidelines, and considers how these elements
are created, adopted and adapted over time.52 ‘Compliance occurs in many circumstances because other
types of behavior are inconceivable; routines are followed because they are taken for granted as “the
way we do these things”’.53 While the concept of the ‘institution’ has been conceptualised in different
ways, it generally refers to the systems of social beliefs and socially organised practices behind every
functioning society. These can include politics, laws, education, religion and regulations.54 Institutional
analysis has traditionally been explored by researchers at the level of the organisational field (e.g.
industry or firm).55
Scott provides a framework, using three levels of analysis that help explain how the higher level environ-
ment affects lower level institutions.56 At the highest level, there are societal and global institutions where
structures are formally proposed. These provide the institutional context which dictates what is acceptable
and legitimate, and facilitates structures at the lower levels. At the next level sits governance structures,
which consist of organisational fields. An organisational field can include the industry, for example, the
Copyright © 2017. Wiley. All rights reserved.

banking sector or the accounting profession. Finally, there are the organisations themselves.
Each level influences, or is influenced by, institutional norms that may have been imposed and seeks
new ways to operate within them or to establish new institutional norms.57 The key assumption within
institutional theory is that all participants seek legitimacy within the institutional environment. That is,
in order to survive, organisations need to conform to the rules and belief systems that prevail in the envi-
ronment and this will earn the organisation legitimacy. 58

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 Much organisational action reflects a pattern of doing things that evolves over time and becomes legit-
imated within an organisation and an environment.59 Consequently practices within organisations can be
predicted from perceptions of legitimate behaviour derived from cultural values, industry tradition, entity
value, and so on.60 Institutional theory proposes three main areas of influence, which leads to similari-
ties across jurisdictions, organisational fields and organisations, referred to as isomorphism.61 Coercive
isomorphism, or institutional pressure, relates to ‘pressures for conformity to public expectations and
demands’.62 The second, mimetic isomorphism, as the name suggests, refers to the tendency to imitate
those other organisations viewed as successful. Finally, normative isomorphism emphasises the collective
values and beliefs that lead to conformity of actions within institutional environments.63
Multinational corporations are likely to face differing institutional environments in which they operate,
and consequently need to adjust their operations accordingly. Similarly, national institutional factors are
likely to play a role in the standard‐setting process64 and it is important for investors, government, regulators
and the accounting profession to understand these influences. An increasing body of research uses institu-
tional theory to explain national adoption of IFRS.65 Across a sample of 132 countries, including developing,
transitional and developed economies that have adopted IFRS, Judge and colleagues found that institutional
pressures resulting from all three areas of isomorphism can explain why some countries fully embrace or
partially adopt IFRS while others reject the standards.66 Research that has examined countries in the Middle
East found that IFRS adoption was in response to pressures primarily from international agencies such as
the World Bank, the International Monetary Fund, World Trade Organization, trade partners, multinational
corporations and the accounting profession.67 Eisenhardt examined compensation in the retail sector and
developed hypotheses relating to the factors likely to influence retail sales compensation under both agency
and institutional theories.68 She proposed, from an institutional perspective, that the age of the retail store was
likely to affect the type of salaries awarded. Older, more traditional stores were likely to use commissions (a
practice that had been developed in the 1950s) while newer stores, operating under a changing institutional
environment, were more likely to provide salaries to staff. The nature of merchandise sold was also likely to
affect whether staff received a salary or commission. High‐priced merchandise, which had its roots in early
department stores, was likely to attract a commission.
Campbell proposed that corporate social performance is likely to relate to the institutional environment
the entity faces, including legislative forces.69 The author argued that corporations were more likely to act
in socially responsible ways if strong and well‐enforced state regulations or a system of well‐organised
and effective industrial self‐regulation were in place; or if their performance and behaviour was monitored
by independent organisations such as non‐governmental organisations, institutional investors or the press.
Similarly, if trade or employer associations were well organised and entities had ongoing dialogue with
these associations, it was expected that their social performance would be stronger.
Institutional factors have also been found to affect corporate stance on climate change. Kolk, Levy
and Pinkse note a shift in entities in energy and transport‐related sectors investing substantial amounts
in low‐carbon technologies and engaging in voluntary schemes to measure, reduce and trade carbon
emissions.70 The authors point to a number of factors likely to influence this change; senior managers
have interacted with others on a range of industry associations and climate negotiations, which has
led to a convergence in their perceptions and actions about climate change. The authors argue that the
global agenda on climate change has become a more important influence on corporate strategy than
institutional influences from the entities’ home countries.

5.4 Legitimacy theory

Copyright © 2017. Wiley. All rights reserved.

LEARNING OBJECTIVE 5.4 Evaluate legitimacy theory and the notion of the social contract and apply it
to accounting practice and disclosure.
Legitimacy theory has been used to understand corporate action and activities, particularly relating to
social and environmental issues. As such, it is a ‘positive theory’. It is based on what has been termed a
‘social contract’.

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 Social contract
The idea of a social contract is drawn from political economy theory. Political economy theory
examines the relationships or interplay between government, law, property rights and the economy.
It relates to how society, politics and economics all interact,71 and means that we cannot talk about
economic or business issues without considering the social and institutional framework within which
it takes place.72
A social contract has often been used to describe how business interacts with society. It relates to the
explicit and implicit expectations society has about how businesses should act to ensure they survive into
the future. A social contract is not necessarily a written agreement, but is what we understand society
expects. Some expectations could be explicit (legislation relating to pollution or employee health and
safety are examples of explicit expectations), while others are implicit. Evidence of implicit terms of
the social contract can be gained from the writing and other communications of a society at a point in
time.73 Membership of environmental groups, or media attention devoted to high executive bonus pay-
ments when share prices are declining could be examples of the degree of public importance placed on
these issues.
Donaldson says that businesses receive their permission to operate from society and are ultimately
accountable to society for how they operate and what they do.74 That is, an organisation needs
to show it is operating in accordance with the expectations in the social contract. The process of
maintaining that an organisation is meeting the expectations of society is known as organisational
legitimacy.75

Organisational legitimacy
Organisational legitimacy, or ‘legitimacy theory’, also comes from the political economy perspective.76
While the relationship between business and society is explained by a social contract, legitimacy theory
can be used to explain the process by which this social contract is maintained. The theory argues that
organisations can only continue to exist if the society in which they operate recognises they are oper-
ating within a value system that is consistent with society’s own.77 This means that an organisation must
appear to consider the rights of the public at large, not just its shareholders.
The values and norms evident in the social contract have changed over time. In the past, legitimacy
was considered only in terms of economic performance, with the only expectation of business being to
make a profit for its owners.78 In 1962, Milton Friedman, in discussing the responsibility of corporate
managers, stated that:

there is one and only one social responsibility of business — to use its resources and engage in activities
designed to increase its profits so long as it stays within the rules of the game  .  .  .79

This has changed and businesses are now expected to consider a range of issues, including the environ-
mental and social consequences of their activities. For example, employees have expectations relating to
the range of benefits their employer provides, and the community might be concerned about air or water
pollution affecting the immediate environment and what an entity is doing to minimise these. Customers
may also be interested in the potential decline in service through business rationalisation and staff cuts
or branch closures. Westpac acknowledged that when it closed bank branches in rural areas between
Copyright © 2017. Wiley. All rights reserved.

1990 and 1998, it broke its ‘social contract’ with the community.80 During a period of high competition
following deregulation of the banking sector, several banks closed branches and agencies across the
country, many in rural areas.81
Contemporary issue 5.2 considers whether the implicit social contract between medical practitioners
and the public (in return for financial reward and status, doctors are expected to meet the medical needs
of society) is still relevant today.

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 5.2 CONTEMPORARY ISSUE

Power and duty: is the social contract in medicine still relevant?

Training physicians is a significant public investment. It
occurs predominantly in publicly funded universities and
health‐care facilities and it’s expected that doctors, in
turn, will place the needs of individual patients and society
above self‐interest. But this idea is now being challenged.
In 2008, Richard Scheffler, a US health economist, esti-
mated the cost of training one doctor to be approximately
$1 million. While there are no firm figures available in Aus-
tralia, it’s plausible that similar training costs are incurred
here.
The expected return on this investment for the public is
that doctors will serve the health needs of the community
with competent, ethical and professional care. Although rarely explicitly stated, it’s expected that phys-
icians will act with humanity, integrity and care. And, on an individual level, it seems that most do.
Those training as doctors also make a substantial personal investment of resources, time and intel-
lect. Lengthy years of training coupled with high levels of individual responsibility and professional
accountability are the norm.
In return for their efforts, doctors are given considerable professional autonomy, respect, social pres-
tige and financial reward. As a result of their specialised knowledge — and the unique power that
comes with it — they are afforded privilege and trust above that of many other professional groups.
This reciprocity is the basis of the social contract in medicine, which emerged in the 19th century.
In return for status and financial rewards, physicians would meet the medical needs of society through
service and altruism.
Threats to the social contract
The expectation of reciprocity inherent within this social contract still arguably influences how health
care is funded and structured in this country. But the fundamental spirit of this contract appears under
threat on a number of fronts.
First, there’s rising disquiet that financial interests are driving the ‘corporatisation’ of healthcare. For some,
the drift towards private‐for‐profit medicine sits uncomfortably beside community commitment to provide
(through tax revenue distributed by government) universally‐accessible and publicly‐funded health care.
In his recent analysis of Medicare expenditure, former director of the Professional Services Review
(PSR), Tony Webber, noted that an estimated two to three billion dollars are inappropriately spent every
year. Much of this, he claims, arises from misuse of medical benefits scheme funding by individual
physicians and corporate owners of medical businesses. Such observations undermine public trust in
doctors and in their social contract.
Regarding medical care purely as a business transaction places the clinical encounter at the intersection
of commerce and science — away from its traditional place at the nexus of humanity and science. For the
public, this may be seen as a moral shift that signals doctors will place self‐interest above the common good.
In Australia, calls for generalist primary carers to service population needs, particularly in rural areas,
remain unmet while numbers of urban specialists continue to grow. Armstrong and his colleagues
reported in 2007 that access to health care was becoming less equitable, out‐of‐pocket expenses were
growing, and health inequality between the rich and poor was not reducing.
Under the social contract, what can society reasonably expect from doctors to meet community
needs? And should community needs and expectations be made more explicit?
Source: Extract from Eleanor Milligan & Sarah Winch, ‘Power and duty: is the social contract in medicine still
relevant?’, The Conversation.82
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QUESTIONS
1. What is a ‘social contract’?
2. The article discusses some of the implied terms of the social contract between doctors and patients.
Articulate what these are and discuss how they are currently under threat.

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 Legitimacy theory indicates that if an organisation cannot justify it is maintaining its operations in
accordance with the social contract, then the community may revoke that contract.83 Customers might
seek alternative sources of products or services, workers may choose other organisations to provide their
labour services to, or organisations might find it more difficult to attract sources of either debt or equity
capital.
The media is often one of the main factors that sets or reflects the agenda embodied within the social
contract. O’Donovan considered how Australian corporate executives responded to potentially damaging
media attention.84 He found that corporations pay close attention to issues highlighted by the media, and
they in turn present disclosures to either support or counteract any misconceptions that may have come
through the media. They saw the media as an important factor in influencing societal views. Pollach
explored how closely aligned the media agenda and the corporate environmental agenda are across a
10‐year period. She found that they very closely mirrored each other but the agenda set by the media
through news coverage regarding environmental issues affected how companies chose to then present
their information in environmental and annual reports.85 This was particularly true for issues dealing
with carbon emissions and the carbon footprint. News coverage, when companies have been exposed for
pollution offences, have also been found to influence corporate practices by stopping the activity leading
to pollution. This has been found especially where the news coverage is more negative and where it is
local, rather than national.86

Accounting disclosures and legitimation

Organisational legitimation is the process an organisation uses to address societal expectations. It is in
the best interests of organisations to take action to ensure their operations are seen to be legitimate in
terms of the implied social contract that exists. Lindblom identifies four ways an organisation can obtain
or maintain legitimacy.
1. Seek to educate and inform society about actual changes in the organisation’s performance and
activities.
2. Seek to change the perceptions of society, but not actually change behaviour.
3. Seek to manipulate perception by deflecting attention from the issue of concern to other related
issues.
4. Seek to change expectations of its performance.87
Legitimation can occur through performance, or through disclosure.88 Entities can change their organ-
isational processes or systems, but this can be very costly. If an entity is going to do this, it is also likely
to publicly disclose information about its activities. For instance, an entity might disclose its sustain-
ability policy on its website, together with information about the environmental management system
it has implemented, and how it is measuring and documenting carbon emissions — an issue that is
of increasing importance to society. The strategies taken by entities are going to differ depending on
whether they are trying to ‘gain legitimacy, to maintain current levels of legitimacy or to repair lost or
threatened legitimacy’.89
Disclosure of information about an organisation’s effect on, or relationship with, society can also be
used in each of the strategies.90 An entity might provide information to offset negative news which may
be publicly available. In addition, organisations may draw attention to strengths, for instance awards
won for environmental performance or reduction in accident rates, while playing down information
about negative activities such as pollution.91
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Public reporting through the annual report or the entity website can be a powerful tool in showing that
an organisation is meeting the expectations of society. One of the major functions of corporate reporting
is to legitimate corporate operations.92 Reflective of its striving for organisational legitimacy, BHP Bil-
liton, in its sustainability report, acknowledged the importance of its ‘licence to operate’ in accordance
with its social contract. In doing so it is seeking to educate and inform society about its performance and

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 activities. In outlining the sustainability approach in its sustainability report, the company presents the
following:
Maintaining our licence to operate as a global company is dependent upon gaining access to natural resources
and ensuring we build long‐term relationships with our shareholders, employees, contractors, communities,
customers and suppliers. Our BHP Billiton Charter value of Sustainability is core to our strategy, ensuring we
integrate health, safety, environmental, social and economic factors into our decision making.93
Legitimacy theory has commonly been used to explain disclosure of sustainability or corporate social
and environmental information. One of the first studies to do this in Australia was carried out by Guthrie
and Parker, where they examined the disclosure practices of BHP from 1885 to 1985.94 They were able
to track a history of growth, decline and change in social disclosure over time rather than a period of
sustained growth. When applying legitimacy theory to explain changing disclosures, Guthrie and Parker
matched them to major events and issues that affected BHP throughout its history. When they did this,
they found that the peak in environmental disclosures in the 1970s was associated with a time when
mining, steel and oil industries became targets for criticism by conservationists. However, they did not
find any support for the theory with other disclosure areas, such as human resources.
Research is more likely to find support for legitimacy theory to explain environmental or social dis-
closure policies when entities are in a position where their legitimacy is threatened. Deegan and Rankin
found companies that had been prosecuted by environmental protection authorities for breaches of
environmental protection laws presented more ‘good news’ surrounding these prosecutions and this type
of disclosure increased at this time. Only two firms sampled made any mention of the prosecutions.
It was concluded that disclosure was used as a strategy to reduce the effects upon the entity of events
that were considered to be unfavourable to the corporate image.95 In a recent study exploring the res-
ponse to climate change by key bodies in the Australian mining industry, the authors conclude that
a combination of legitimation strategies is carried out, but to differing degrees depending on the organ-
isation.96 These include lobbying government, media releases, disclosures of member firms in annual
and sustainability reports, and collaborating with non‐government organisations such as Greenpeace.

5.5 Stakeholder theory

LEARNING OBJECTIVE 5.5 Evaluate stakeholder theory and apply it to accounting disclosure.
While legitimacy theory relates to organisational consideration of society in general, stakeholder theory
considers the relationship with discrete stakeholders rather than society as a whole. Stakeholders have
been defined by Freeman as ‘any group or individual who can affect or is affected by the achievements
of an organisation’s objectives’.97 Figure 5.1 reflects the range of stakeholders an organisation needs to
consider in its decision‐making process.98
Stakeholder theory relates to the ethical or moral treatment of organisational stakeholders. Hasnas ident-
ifies the characteristics of entities to which stakeholder theory can apply: entities that are ‘voluntary associ-
ations (1) formed to realize specified aims and purposes (2) that allow members to freely exit (and freely
eject other members from) the association, and (3) that attract and retain (as well as recruit and evaluate)
members on the basis of their interest in advancing the association’s objectives’.99 Consequently, the theory
is not limited to profit‐generating entities; it can be applied to non‐profit businesses including charities. While
for‐profit entities need to generate profits for shareholders and other financiers, non‐profit entities do not.
Shareholders might sell their shares in profit‐generating entities, while donors may decide whether to donate
Copyright © 2017. Wiley. All rights reserved.

or not to a non‐profit entity. However, both allow employees to freely leave.100

Our understanding of stakeholder theory has changed over the past five to ten years. The literature
previously suggested that three branches of the theory existed:
1. a normative or ethical branch
2. an instrumental branch
3. a descriptive or positive branch, often referred to as the managerial branch.101

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 FIGURE 5.1 Organisational stakeholders

Political
Governments Investors
groups

Suppliers FIRM Customers

Trade
Employees Communities
associations

Source: Donaldson & Preston.

Under the ethical branch, it was proposed that organisations should treat all their stakeholders fairly
and an organisation should be managed for the benefit of all its stakeholders.102 Stakeholder importance
is not determined by the supply of resources to the organisation. This means that one stakeholder is not
perceived to be any more important than any other and organisations have a fiduciary duty to all their
stakeholders.103 Donaldson and Preston note that stakeholders are important when identifying the ‘moral
or philosophical guidelines for the operation and management of the corporation’.104 The instrumental
branch is used to identify connections between the management of stakeholders and achievement of tra-
ditional corporate objectives such as profitability or growth.105
The managerial branch of stakeholder theory was proposed as a mechanism to explain how stakeholders
might influence organisational actions. The extent to which an organisation will consider its stakeholders,
under this version of the theory, was argued to relate to the power or influence of those stakeholders. A
stakeholder’s power was proposed to be related to the degree of control they have over resources required
by the organisation.106 The more necessary the resources that the stakeholder controls are to the success of
the organisation, the more likely that managers will address the stakeholder’s concerns.
While forming the theoretical basis of much research in the area, this version of the theory, encom-
passing the ‘principle of who and what really counts’, represented by stakeholder power has been
discounted by prominent stakeholder theorists.107 They argue that we cannot distinguish between
different branches of the theory. These theorists (one of whom is Ron Freeman, arguably the ‘father’
of stakeholder theory) believe that all variants have elements of the other embedded within108 and
see ‘stakeholder theory’ as a framework, a set of ideas from which a number of theories can be
derived’.109
Copyright © 2017. Wiley. All rights reserved.

Stakeholder theory proposes that organisations have an obligation to consider how their operations
affect stakeholders and should not merely concentrate on maximising profit for the benefit of owners.
Hasnas notes that in giving consideration to the interests of all stakeholders, managers need to manage
the business to attain optimal balance among these stakeholders.110 At times there will likely be con-
flicting interests, so it falls on management to partially sacrifice the interests of some shareholders to

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 meet those of other stakeholders.111 Freeman suggests entities need to work to harmonise the interests
of stakeholders:

In harmony the notes are different but they sound good together. Stakeholder interests are different but
the idea is you want them to work together, to sound good together – even when there’s conflict…When
you find conflict, that’s a place where you can create value, so you have to think about stakeholder inter-
ests and where the conflict is – not in a balancing or trade‐off sense, but in a value‐creations sense.112

Stakeholder theory is consistent with the idea of value maximisation, with stakeholder theorists
arguing that entities seeking to serve the interests of a broad group of stakeholders will create more value
over time.113 While positive accounting theory and agency theory see this to be maximising shareholder
wealth, stakeholder theory takes a broader perspective of value creation. Freeman argues ‘it’s a mistake
to restrict the idea of “value” to just financial value’. He instead, proposes that value encompasses all the
things that customers, employees and other stakeholders find valuable’.114 He believes ‘it’s not all about
competition, greed, self‐interest, and a willingness to do whatever it takes to maximise profits for share-
holders’.115 Harrison and Wicks support this view, arguing that a focus on economic value is ‘contrary
to the underlying philosophy that has characterized stakeholder theory emphasizing the “joint‐ness” of
stakeholder interests and the need to all stakeholders to benefit over time through their cooperation’.116
Freeman believes profits are a necessary outcome of business; but they are not its sole purpose.117

Role of accounting information in stakeholder theory

One important way of meeting stakeholders’ needs and expectations is providing information about
organisational activities and performance. This might be demonstrating how the strategic direction,
mission or objectives align with the stakeholders’ expectations, or how the organisation’s financial or
environmental performance meets stakeholders’ requirements. Consistent with Lindblom’s legitimating
strategies discussed previously, providing information to stakeholders is one very important way to gain
the support or approval of stakeholders, or to deflect their attention from less desirable activities.118
Freeman sees that accounting has a significant role to play in a stakeholder‐dominated view of the
world. However, he argues that the business model needs to change to provide information to a range
of stakeholders on how the entity creates value.119 One recent initiative that may meet Freeman’s
needs for information about value creation is integrated reporting. Integrated reporting is designed to
create a globally accepted reporting framework that brings together financial, environmental, social
and governance information, and aims to present a more holistic view of the value generated for
stakeholders.
As with legitimacy theory, stakeholder theory has been used to examine disclosure of voluntary infor-
mation to stakeholders, most commonly relating to social and environmental performance. Williams and
Adams examined how disclosure of employee issues by a large UK bank was used to promote transparency
and accountability toward the employee stakeholder group. Examining reporting over a 15‐year period,
the authors found that reporting practices were issue and context dependent. They argue that reporting to
employees should extend beyond a stakeholder management perspective and that there is a need to con-
sider the complexity of the role of disclosure in stakeholder relationships. They also state that one theoretical
framework may not be sufficient to explain these complex reporting issues.120 Bae, Kang and Wang also
examine the firm’s relations with its employee stakeholders, finding firms that treat their employees fairly
have improved capital structure in the form of lower debt ratios. The authors propose that an entity’s incen-
Copyright © 2017. Wiley. All rights reserved.

tive or ability to offer fair treatment to its employees is an important determinant of financing policy.121
In another study investigating how firms manage their stakeholder relationships, Islam and Deegan
explore social and environmental disclosure practices of the Bangladesh Garments and Manufacturing
Enterprise Association (BGMEA), the organisation authorised to grant export licences to garment manu-
facturers.122 In addition to evaluating disclosures, the authors also interviewed senior executives from
BGMEA. The executives highlighted the importance of its multinational buying companies in determining

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 operating and disclosure policies. They also expressed the view that the extent of pressure from multi-
national buying companies was influenced by Western consumers who, in turn, were influenced by the
Western media. Media reports about poor working conditions for employees and the use of child labour
led to consumers boycotting products of these large multinational clothing companies, who imposed oper-
ating and reporting requirements on suppliers, in particular relating to employee conditions.123

5.6 Contingency theory

LEARNING OBJECTIVE 5.6 Evaluate contingency theory in terms of its application to accounting
practice and disclosure.
Contingency theory was developed in management literature in the 1960s and 1970s.124 In essence, the
theory proposes that organisations are all affected by a range of factors that differ across organisations. As a
result, they need to adapt their structure to take into account a range of factors such as the external environ-
ment, organisational size and business strategy, if the organisation is to perform well.125 Galbraith formulated
the theory to propose that there is no one best way to organise, as organisational effectiveness is contin-
gent on context.126 The central proposition of contingency theory is that organisational performance depends
on the fit between organisational context and structure.127 In turn, organisational effectiveness is achieved
by matching organisational characteristics to contingencies.128 A ‘contingency’ is defined as ‘any variable
that moderates the effect of an organizational characteristic on organizational performance’.129 A number
of contingencies have been identified in the literature examining organisational structure and performance,
including technology, innovation, environmental change, size and diversification.130
Contingency frameworks have been used to evaluate management accounting information and internal
control systems (see for example Otley131 and Chenhall132). The contingency approach in management
accounting is based on the proposition that there is no universally appropriate accounting system that
can be applied to all organisations. Instead, features of appropriate accounting systems are contingent
upon the specific circumstances the organisation faces.133 Contingency theory has been used by Jokipii
to examine the effectiveness of internal control systems.134 The author takes a contingency approach to
examining the design of the internal control systems and the important contingency characteristics that
should be taken into account when focusing on internal control, and that impact on its effectiveness.
Jokipii observes that entities adapt their internal control structure to deal with environmental uncertainty.
Entity strategy is also found to impact on internal control structure.135
In their study of strategic management accounting, Cadez and Guilding find support for a contin-
gency proposition that there is no universally appropriate strategic management accounting system, with
factors such as entity size and strategy found to impact on the successful application of strategic man-
agement accounting systems.136

Comparison of theories
Table 5.1 compares the concepts underlying each theory discussed in this chapter.
TABLE 5.1 Comparison of theories

Institutional Legitimacy Stakeholder Contingency

Agency theory theory theory theory theory

Key idea Organisational Organisational Organisational Organisational Organisational

practices arise practices arise practices arise practices practices
Copyright © 2017. Wiley. All rights reserved.

from efficient from imitative from the implied arise from arise from the
organisation of forces and firm expectations considerations need to adapt
information and traditions. in a social of stakeholders to consider
risk‐bearing costs. contract. to create value. external forces.

Basis of Efficiency Legitimacy Legitimacy Efficiency Legitimacy

organisation

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 TABLE 5.1 (continued)

Institutional Legitimacy Stakeholder Contingency

Agency theory theory theory theory theory
View of Self‐interested Legitimacy — Legitimacy — Manage Legitimacy —
people rationalists. seeking seeking interests of all seeking
satisfiers. satisfiers. stakeholders. satisfiers.
Role of Organisational A source of A source of Organisational Organisational
environment practices should practices practices practices practices
fit environment. to which to which should fit should reflect
organisation organisation environment. environment.
conforms. conforms.
Assumptions People are People are People change Utility Organisational
self‐interested. satisfied. expectations maximisation effectiveness is
People are People conform over time, is a primary contingent on
rational. to external reflected in a objective but context.
norms. social contract. not limited to
People are risk
financial wealth.
averse.

Source: Adapted from Eisenhardt.137

The next section considers how the theories discussed in this chapter can be used to understand
accounting decisions. Many of these accounting issues are discussed in more detail elsewhere in this book.

5.7 Using theories to understand accounting

decisions
LEARNING OBJECTIVE 5.7 Reflect on the different decisions made by accounting practitioners, evaluate
and justify how theories can be used to explain a range of decisions.
Accountants need to make a range of accounting decisions on a daily basis. In your accounting studies
to date you probably have been given precise information as to, for example, the expected useful life
of non‐current assets, the depreciation method that is to be used, the percentage of accounts receiv-
able anticipated to eventuate as bad debts and the amount of impairment. In reality, this is not the case.
Accountants are required to use judgement to make a range of decisions including:
•• whether to expense or capitalise costs
•• what accounting estimates to use
•• whether to recognise an item in the body of the financial statements, or disclose it in the notes only
•• whether to disclose additional information, where it is not governed by legislation.
The theories discussed in this chapter can offer some assistance in explaining managers’ and account-
ants’ decisions in these areas.

Expensing and capitalising costs

Accountants and managers need to make decisions about the timing and nature of a range of activities
including maintenance, machinery overhaul, capital improvements and repairs. While the accounting stan-
dard relating to lease transactions is due to change at time of writing, entities, as lessees, are also required to
Copyright © 2017. Wiley. All rights reserved.

decide if they have taken on the risks and rewards of ownership and thus are required to capitalise the leased
asset and corresponding liability. Accountants often have discretion over the timing of the recording of these
events and many are likely to have considerable impacts on the financial position and performance of the
entity. Expensing a transaction rather than capitalising it is likely to reduce short‐term profits. Similarly,
capitalising is expected to increase the asset base and therefore improve leverage calculations. Agency
theory would hold that managers on compensation contracts with bonuses tied to a current measure of entity

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 performance, such as profits, would prefer to capitalise these costs, if possible, in order to maximise profits.
Similarly, where the entity has a lending agreement with a leverage covenant, managers will want to ensure
the value of assets is maximised, which will lead to capitalising costs where possible.
If managers’ compensation contracts include measures of medium‐ or long‐term entity performance
in order to extend the managers’ time horizon, capitalising costs becomes less important and managers
are likely to want to smooth income over the medium to long term.138 Institutional theory would also
explain the influence of external norms and expectations on managerial compensation policy. Entities
would be expected to follow what are perceived to be ‘normal’ practices in the industry in setting pay
and using a mix of cash and incentive pay.

Accounting estimates
Accountants and managers constantly estimate economic magnitudes to bring to account. Bad debts, pro-
visions for warranties, the expected useful life and salvage value of plant and equipment, impairment of
assets and the fair value of financial instruments are just some of these. These estimates require a great deal
of judgement and can lead to substantial variations in reported profits and asset balances. Again, agency
contracts can explain managerial decisions in this regard. Managers and accountants, acting in self-interest,
are likely to ensure their own bonuses are maximised and the entity is not at risk of breaching debt contracts.

Disclosure policy
Beyond the specific legal and accounting standard requirements, managers and accountants decide the
extent and location of additional disclosures within the annual report.139 Disclosure policy relates to
additional disclosure within the financial statements or notes to the financial statements, in the directors’
report or review of operations, additional sections of the annual report or media releases.
Disclosures could relate to financial forecasts, information about social or environmental performance,
capital investment plans or research and development opportunities, amongst others. Stakeholder theory
would explain these disclosures in terms of providing relevant information to maintain relationships with
powerful stakeholders. Legitimacy theory sees voluntary disclosure as a way of maintaining or regaining
legitimacy by demonstrating how the entity is meeting societal expectations. The theory has been used to
explain disclosure of voluntary environmental information where entities are facing a legitimacy risk due
to environmental disasters or poor environmental performance (see for example Deegan & Rankin140
and Patten141). Similarly, institutional theory and contingency theory would explain disclosure policy in
relation to the expectations of the norms and external environment.
Information asymmetry between owners and managers is likely to influence the extent and type of
information entities disclose. Managers need to be mindful of presenting both good and bad news about
the entity, or risk the reputation of the entity and potentially influence entity value.
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 SUMMARY
5.1 Evaluate how theories can enhance our understanding of accounting practice.
•• Theories can be used to explain and understand accounting practice. They can also be used to
prescribe methods to improve accounting practice.
5.2 Integrate knowledge about positive accounting theory and agency theory and apply them to agency
contracts between owners, managers and lenders to explain accounting practice and disclosure.
•• Positive accounting theory is based on contracting and agency theories and provides guidance on
what accounting methods managers are likely to choose given the contracts in place.
•• Agency theory concentrates on two agency relationships: the relationships between owners as
principals and managers as their agents; and the contractual relationship between lenders as
principals and managers, acting on behalf of owners, as agents.
•• Contracting is designed to reduce monitoring and bonding costs, and to reduce the resulting
residual loss.
•• The agency problems arising from the owner–manager contractual relationship are:
–– risk aversion, where managers have incentives to undertake less risky decisions than owners
would like, which leads to limiting the potential for long‐term value
–– dividend retention, where managers retain funds within the organisation which can be
used to expand the business, and increase their ‘empire’ rather than pay these profits out to
shareholders as dividends
–– the horizon problem where managers have an incentive to focus on short‐term entity
performance, while shareholders are interested in the long‐term growth of entity value.
•• There are also agency problems relating to the contractual relationship between lenders and managers.
–– Excessive dividend payment is a problem where payment of higher dividends could lead to a
reduced asset base securing the debt, or leaving insufficient funds within the entity to service
the debt.
–– Underinvestment arises when managers, on behalf of owners, have incentives not to undertake
positive NPV projects if the projects would lead to increased funds being available to lenders.
–– Asset substitution arises when lenders lend funds on the assumption that managers will not
invest in assets or projects of a higher risk level than agreed. Because managers are working on
behalf of owners, and are often owners themselves, they have incentives to use the debt finance
to invest in alternative, higher risk assets in the likelihood that it will lead to higher returns
to shareholders.
–– Claim dilution is when entities take on debt of a higher priority than that on issue. While
taking on additional debt increases funds available to the entity, it decreases the security to
lenders, making the lending more risky.
•• Contracts can be written to reduce agency problems, with many of these contractual terms relying
on accounting information. Accounting information plays two important roles in the contracting
process including:
–– forming part of the contracts
–– monitoring performance against the contractual terms.
•• Information asymmetry is likely to influence corporate disclosure policy as entities are likely
to be concerned about their reputation and the impact on entity value if they fail to disclose
pertinent information.
Copyright © 2017. Wiley. All rights reserved.

5.3 Evaluate institutional theory in terms of its application to organisational structures and apply the
theory to accounting practice and disclosure.
•• Institutional theory has been used extensively in management literature and is increasingly used
in accounting research to understand the influences on organisational structures. It considers how
rules, norms and routines become established as authoritative guidelines and considers how these
elements are created, adopted and adapted over time.

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 5.4 Evaluate legitimacy theory and the notion of the social contract and apply it to accounting practice
and disclosure.
•• Legitimacy theory has been used to understand corporate action and activities, particularly relating
to social and environmental issues. It is based on what has been termed a ‘social contract’.
•• A social contract is used to describe how business interacts with society. It relates to the explicit
and implicit expectations society has about how businesses should act to ensure they survive into
the future.
•• Businesses receive their permission to operate from society and are ultimately accountable to
society for how they operate and what they do.
•• Where the relationship between business and society is explained by a social contract, legitimacy
theory can be used to explain the process by which the social contract is maintained.
•• Disclosure of information about an organisation’s effect on, or relationship with, society can also
be used as a legitimising strategy. An entity might provide information to offset negative news
which may be publicly available. Organisations may also draw attention to strengths. One of the
major functions of corporate reporting is to legitimise corporate operations.
5.5 Evaluate stakeholder theory and apply it to accounting disclosure.
•• Stakeholder theory considers the relationship with discrete stakeholders rather than society as a
whole. It relates to the ethical or moral treatment of organisational stakeholders.
•• The literature previously suggested three branches of the theory (normative or ethical branch;
instrumental branch; descriptive or managerial branch). However, this view has recently been
discounted in favour of a view that we cannot distinguish between different branches of the
theory.
•• Stakeholder theory proposes that organisations have an obligation to consider how their operations
affect stakeholders and should not merely concentrate on maximising profits for the benefit of
owners.
•• Information about organisational activities and performance is one important way of meeting
stakeholders’ needs and expectations. The theory has been used to examine disclosure of voluntary
information to stakeholders. most commonly relating to social and environmental performance.
5.6 Evaluate contingency theory in terms of its application to accounting practice and disclosure.
•• The theory proposes that organisations are all affected by a range of factors that differ across
organisations. Organisations need to adapt their structure to take into account a range of factors
such as external environment, organisational size and business strategy if the organisation is
going to perform well.
5.7 Reflect on the different decisions made by accounting practitioners, evaluate and justify how theories
can be used to explain a range of decisions.
•• Accounting practitioners and managers make numerous decisions on a daily basis. These include
expensing–capitalising decisions, accounting estimates, whether to recognise an item in the
body of the financial reports or disclose it in the notes only, and whether to disclose additional
information, where it is not governed by legislation.

KEY TERMS
accounting decisions  the decisions made by accountants relating to financial statement elements
Copyright © 2017. Wiley. All rights reserved.

including measurement, estimation, recognition, presentation and disclosure

adverse selection  a situation in which sellers have relevant information that buyers lack (or vice versa)
about some aspect of product quality
agency relationship  a relationship where one party (the principal) employs another (the agent) to
perform some activity on their behalf. In doing so the principal delegates the decision‐making
authority to the agent.

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 agency theory  a theory concerning the relationship between a principal and an agent of the principal
asset substitution  a problem that arises when an entity invests in assets or projects at a higher risk
level than that agreed with lenders, thus transferring value from the entity’s debtholders to its
shareholders
bonding costs  the restrictions placed on an agent’s actions deriving from linking the agent’s interest to
that of the principal
claim dilution  a decline in the probability that a lender will be fully repaid, usually as a result of an
entity taking on a higher priority debt
contingency theory  the theory that organisations are all affected by a range of factors that differ
across organisations. Organisations need to adapt their structure to take into account a range of
factors if the organisation is going to perform well.
contracting theory  a theory that organisations are characterised as a ‘legal nexus of contracts’, with
contracting parties having rights and responsibilities under these contracts
debt covenants  terms or conditions included in debt agreements that limit or require certain behaviour
of the borrower. Common examples include leverage, dividend payout, interest coverage and
working capital ratios.
dividend retention problem  the reduced incentive of managers to pay dividends or take on optimal
levels of debt
excessive dividend payments  the overpayment of dividends which may lead to a reduction in the
asset base securing a debt or leave insufficient funds within an entity to service a debt
horizon problem  the differing time horizons between the owners of an entity who are interested in the
long‐term growth and value of an entity and managers of an entity who are interested in short‐term
profitability
information asymmetry  the impact of managers having an advantage over investors and other
interested parties as they have more information about the current and future prospects of the firm,
and can choose when and how to disseminate this information
institutional theory  a theory used to understand the influences on organisational structure; how rules,
norms and routines become established as authoritative guidelines; and how these elements are
created, adopted and adapted over time
isomorphism  relating to close similarity or correspondence between two or more things. In the context of
institutional theory it relates to similarities across countries, industries or organisations resulting from
coercion, imitating others or conformity of action resulting from shared values and beliefs
legitimacy  the process by which organisations demonstrate they are operating within a value system
consistent with society’s expectations
legitimacy theory  a positive theory used to understand corporate action and activities, particularly
relating to social and environmental issues
monitoring costs  costs incurred by principals to measure, observe and control the agent’s behaviour
moral hazard  the risk that an agent might undertake actions that are detrimental to a principal
normative theory  a theory which prescribes what should happen
positive accounting theory  a positive theory used to explain and predict accounting practice
positive theory  a theory that describes, explains or predicts what is happening in the world (such as
describing, explaining or predicting current accounting practice)
price protection  the ability of principals to transfer the costs of monitoring to agents; this could
include compensating managers less or increasing the costs of borrowing
Copyright © 2017. Wiley. All rights reserved.

residual loss  the reduction in wealth of principals caused by their agent’s non‐optimal behaviour
risk aversion  the behaviour of an investor who prefers less risk to more risk, all else being equal
social contract  the explicit and implicit expectations society has about how entities should act to
ensure they survive into the future
stakeholder theory  a theory that incorporates the interests of a broader range of stakeholders in an
entity, not just the shareholders

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 stakeholders  those individuals or groups existing in society that an organisation impacts, and/or that
have an influence on an organisation
underinvestment  an agency problem whereby managers have incentives not to undertake positive net
present value projects which would lead to increased funds being available to lenders

REVIEW QUESTIONS
 5.1 What is the underlying assumption of positive accounting theory, and how can it be used
to understand the problems that exist between owners and managers? LO2
 5.2 Explain what an agency relationship is, and explain the following costs: monitoring costs, bonding
costs, residual loss. LO2
 5.3 Why would managers’ interests differ from those of shareholders? What can shareholders do to
ensure that they do not suffer financially because of this difference in interests? LO2
 5.4 Explain the three agency problems that exist in the relationship between owners and
managers. LO2
 5.5 Explain the four agency problems that exist in the relationship between lenders and managers. LO2
 5.6 What is a debt covenant and, from an agency theory perspective, why is it used in lending
agreements? LO2
 5.7 Why would managers agree to enter into lending agreements that incorporate covenants? LO2
 5.8 What are the costs of breaching a debt covenant? LO2
 5.9 What role does accounting play in reducing agency problems? LO2
5.10 How can shareholders mitigate the risk that managers will transfer wealth from shareholders
to themselves? Provide specific examples and explain how they work to limit these wealth
transfers. LO2
5.11 How might institutional theory explain accounting disclosures? LO3
5.12 Using institutional theory, evaluate the factors that might lead a country to adopt international
financial reporting standards, rather than its local standards. LO3
5.13 What is a social contract and how does it relate to organisational legitimacy? LO4
5.14 How can corporate disclosure policy be used to maintain or regain organisational legitimacy? LO4
5.15 Why would managers decide to voluntarily disclose environmental performance information in an
annual report? LO7
5.16 How does the idea of value creation under stakeholder theory differ from that under positive
accounting theory? LO5
5.17 Stakeholder theory proposes that it is important to harmonise or balance stakeholders’ needs and
expectations. Choose two stakeholder groups and evaluate how a company can balance the views
of these shareholders in its dealing with them. LO5
5.18 What are the factors a manager might consider in making various expensing–capitalising
choices? LO7
5.19 How can positive accounting theory explain corporate social and environmental reporting? LO2
Copyright © 2017. Wiley. All rights reserved.

APPLICATION QUESTIONS
5.20 Making managerial pay contingent on measures of managerial and/or entity performance motivates
managers to deliver good performance for shareholders. However, it also burdens them with greater
risks than they may like. How do organisations balance these two considerations when choosing
managerial pay and performance measures? LO2

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 5.21 Obtain the remuneration report for a publicly listed company. Examine the compensation contract
for the chief executive officer (CEO). Prepare a report which summarises your findings relating to
the following issues:
(a) What amount is short term in nature (salary and cash bonus) and what is based on long‐term
entity or managerial performance?
(b) What proportion of the CEO’s pay is performance based and what proportion is not?
(c) What measures of accounting performance are used to determine the CEO’s bonus?
(d) Given the accounting entity performance measures in the contract, what accounting decisions
could the CEO make in order to maximise his or her bonus?
(e) Can agency theory provide an explanation for the various remuneration components? Justify
your answer. LO2
5.22 Bonus plans are used to reduce agency problems that exist between managers and shareholders.
Discuss two of these problems specific to the relationship between shareholders and managers
and identify how bonus plans can be used to reduce the agency problems you have identified. In
your answer you should provide examples of specific components that should be added to a bonus
contract to address the issues identified. LO2
5.23 You have recently been appointed as a lending officer in the commercial division of a major
bank. The bank is concerned about lending in an economic environment where there has been
an economic downturn. You have been asked by your supervisor to provide a report indicating
how you can safeguard the bank against the risks of lending. In your report you should outline
how covenants in debt agreements can be used to reduce the risks, what agency problems the
bank should be concerned with, and how accounting information can be used to assist in this
process. LO2
5.24 A clothing manufacturer has decided to close its factory in a regional Australian town and move
its operations offshore to a country where they can employ workers at a substantially reduced
cost. Closing the factory will result in the loss of 400 jobs in the town. Outline the issues the
clothing manufacturer might face with regards to its implied social contract. You should identify
what groups or people are likely to be concerned or affected by the decision and whether the
decision is likely to be seen as advantageous or disadvantageous to these groups. You should also
discuss actions the clothing manufacturer could take to reduce any potential negative reaction to
the decision. LO4, 5
5.25 You work for a mining entity which is about to commence exploration in a remote area of the
Northern Territory. You have been asked to assist the mining entity to manage its stakeholders to
ensure the exploration permit is approved and there is no negative publicity associated with the
operation. You are to identify the various stakeholders the mining entity needs to consider and
identify the issues each might be concerned with. In your answer you should identify whether
these issues are potentially costs or benefits to the entity. LO4, 5
5.26 In an article published in the Australian Financial Review it was revealed that across the top‐100
companies, boards are increasingly paying chief executives larger annual cash bonuses to avoid
investor backlash. It was proposed that fixed pay had doubled over a 5‐year period to an average
of $1.8 million. It was suggested that boards were paying higher cash salaries to placate executives
unhappy with having to meet demanding performance hurdles to access options. The article
highlighted the lack of any downside risk for executives with this compensation strategy. Proxy
advisors were also concerned about long‐term performance hurdles in some firms being less
Copyright © 2017. Wiley. All rights reserved.

demanding than would be expected.142

  Shareholders of Australian entities have the ability to vote to show either their support or
dissatisfaction with companies’ remuneration reports. While this is non‐binding on the board, they
are obliged to take note of shareholders’ views. From 2011 if the remuneration report receives
greater than 25% of shareholder votes against it, the board of directors will be spilled and subject
to re‐election.

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   Why might shareholders choose to vote against reports with a large proportion of executive pay as
salary and short‐term cash bonuses? Critically evaluate what impact a vote against the remuneration
report greater than 25% might have on the following years’ remuneration report. LO4, 5, 7
5.27 In April 2013 the crowded Rana Plaza garment factory on the outskirts of Dhaka, the capital of
Bangladesh, collapsed, killing more than 1000 people. Following this, an Accord on Fire and Building
Safety in Bangladesh has been signed by more than 150 global brands. The Accord allows staff to stop
work if their safety is under threat. Some notable Australian firms have yet to sign this accord.143 In
addition, the International Labor Organization, an agency of the UN, set up the Rana Plaza Donors
Trust Fund, which aimed to raise US$30 million to provide compensation to any affected by the
factory collapse. All garment companies that source goods from Bangladesh, and in particular those
using the Rana Plaza factory were invited to donate to the fund, in accordance with their ability to pay,
the size of their relationship with Bangladesh and their relationship with Rana Plaza.144
  You have been appointed as a consultant to a clothing retailer which, while it sources clothing
from factories in Bangladesh, did not have clothing manufactured by the company operating the
Rana Plaza garment factory. The retailer has asked you to evaluate the appropriateness, pros and cons
of signing the Accord on Fire and Building Safety, and of donating funds to the Rana Plaza Donors
Trust Fund. They would also like some advice on the extent to which the entity should disclose
their involvement in garment manufacturing in Bangladesh. In providing a response to the firm, use
appropriate theories explored in this chapter to support your review and recommendations. LO7
5.28 Pick an organisation you are familiar with. List three important classes of participants in this
organisation. Identify the resources that each contributes to and receives from the organisation.
Explain the relationship of each of these classes of participants from both an agency theory
and a stakeholder theory perspective. LO2, 5
5.29 When accounting for non‐current assets accounting standards allow the application of a cost or
a revaluation method. Evaluate the impact of the choice on common debt covenants, including
interest cover and leverage ratios. LO7

5.1 CASE STUDY

AUSGROUP BREACHES DEBT COVENANTS
AusGroup, a Western Australian resources contractor, was forced to retain KPMG as an advisor to help
steer the company out of significant financial difficulty. The company breached a key financial covenant
under a trust deed after its total equity fell below $160 million, requiring it to seek a waiver from holders
of its unsecured notes. The company made this announcement just days after it disclosed net losses of
$94 million over the nine months to March 2016. Its March quarter report also highlighted that current
liabilities exceeded current assets by over $66 million.
The company has been hit hard by the decline in capital expenditure in the oil and gas sector and has
been affected by delays in the environmental and regulatory approval of a fuel facility in the Northern
Territory. While the facility was completed in July 2015, operations have not yet started.
Source: Adapted from M Beyer, ‘AusGroup breaches debt covenant’, Business News Western Australia; P Willams, ‘Battling
AusGroup “facing crisis”, The West Australian.145

QUESTIONS
Copyright © 2017. Wiley. All rights reserved.

1 Debt covenants or restrictions are commonly used in Australian lending agreements. Discuss how they
are used to reduce agency problems that exist in the relationship between entities and lenders. 
2 Why would a company choose to enter into a lending agreement that contains a covenant that puts a
restriction on the maximum debt to assets (leverage) that a company can take on? 
3 Evaluate the costs to AusGroup from breaching the conditions of its debt contract. How can the
company reduce these costs? LO2

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 5.2 CASE STUDY
$10M CEO BONUSES ENCOURAGE SHORT‐TERM DECISIONS
Chief executives with multi‐million‐dollar pay packets are not necessarily working in the best interests
of shareholders and there may be a case to cap their pay. New research explores whether limits on
executive pay hurt or benefit shareholders and suggests that providing CEOs with $10 million bonuses
encourages them to make short‐term decisions rather than work closely with the board and in the best
interest of shareholders. The research proposes that limiting executive compensation might be more ben-
eficial for shareholders.

Over the past 30 years, CEO compensation has been increasing on the basis of a theoretical argument
that it creates shareholder value. However, the current system encourages companies to be ‘transactional
focused’ rather than building capacity and innovating; CEOs are likely to pursue strategies with out-
comes that are easy to measure in financial terms.
It has been proposed that the current corporate governance structure and guidelines in Australia
encourage director independence. But this often means that directors do not have a deep understanding
of the business. Relying on financial performance measures means directors do not need to really
understand  whether CEOs are good leaders, insightful, pursuing the right strategies and communi-
cating well.
Source: Adapted from Nassim Khadem, ‘$10m CEO bonuses encourage short‐term decisions’, The Sydney Morning Herald.146
Copyright © 2017. Wiley. All rights reserved.

QUESTIONS
1 One of the problems in the shareholder/manager agency relationship that pay contracts are designed to
overcome is the horizon problem. Outline what the problem is and how the contract between managers
and shareholders can be designed to reduce the horizon problem. 

168  Contemporary issues in accounting

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 2 The article highlights the excessive use of bonuses to encourage shore‐term decisions. From an agency
perspective, why would managers prefer short‐term cash bonuses instead of long‐term equity bonuses?
What problems does this approach lead to for the board of directors and shareholders? In presenting
your answer you should refer to relevant information in the above article to support your view. 
3 Why would managers prefer short‐term cash over long‐term equity bonuses? Why does this
not align with shareholder interests? Explain your answer. LO2

5.3 CASE STUDY

SUPPLY CHAIN — USING CHILD LABOUR OR PAYING UNFAIR RATES CAN DESTROY A
BRAND
Consumers are becoming increasingly budget‐conscious, which has encouraged retailers to seek
efficiencies through their supply chain. This has led, in many cases, to sourcing stock from manufac-
turers in countries that pay low pay rates. However, this can carry additional risks.

Now investors are calling for greater transparency from public companies over the sourcing of
clothing, footwear and textiles from Asia, warning that chasing cheaper labour to reduce costs can back-
fire and ultimately damage fashion brands. They are putting pressure on public companies to provide
more information about their supply chain, including details of which countries goods are coming from.
It is important for investors to consider which companies are managing these risks, when making
investment decisions. However, public disclosure is often quite poor, leading investors to seek further
Copyright © 2017. Wiley. All rights reserved.

information from other sources; they are seeking greater transparency and have put ethical supply chain
management under the spotlight.
The collapse of a garment factory in Bangladesh in April 2013 that killed more than 1000 workers
increased the focus on the issue and now retailers are expected to disclose the extent to which they
are exposed to one of the poorest countries in Asia and sign international labour agreements on sourcing
and pay.

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 Concerns about sources of goods have existed for years, however. Decades ago, footwear group Nike
was exposed in a sweatshop scandal. That was followed by other scandals, including the discovery that
footballs used in the Australian Football League were made by children.
Investors who are signatories to the UN Principles for Responsible Investment identify supply chain
labour standards as one of their priority areas for engaging with companies.
Source: Adapted from Eli Greenblat, ‘Pressure on retailers to act ethically’, The Age.147

QUESTIONS
1 The above article discusses investors’ call for more transparency in regard to human rights and
employment issues through companies’ supply chains. Many companies discuss this information
in their sustainability report. What is sustainability? Provide three examples of activities that are
considered to have an impact on the sustainability performance of a company.
2 Corporate decisions to voluntarily disclose information about policies and practices relating to human
rights and employment can be explained using a number of theories addressed in this unit. Discuss
one of these theories, and explain, from a theoretical viewpoint, why firms would choose to provide
this information when they are not formally required to do so.
3 How does a company’s supply chain relate to determining sustainability of an organisation’s
operations? Explain your answer, supporting your view with examples from the article. LO7 

ADDITIONAL READINGS
Deegan, C 2002, ‘The legitimising effect of social and environmental disclosures — a theoretical foundation’, Accounting,
Auditing and Accountability Journal, vol. 15, no. 3, pp. 282–311.
Donaldson, T & Preston, LE 1995, ‘The stakeholder theory of the corporation: concepts, evidence and implications’, Academy of
Management Review, vol. 20, no. 1, pp. 65–91.
Gray, R, Kouhy, R & Lavers, S 1995, ‘Corporate social and environmental reporting: a review of the literature and a longitudinal
study of UK disclosure’, Accounting, Auditing and Accountability Journal, vol. 8, no. 2, pp. 47–77.
Jensen, M & Meckling, W 1976, ‘Theory of the firm: managerial behaviour, agency costs and ownership structure’, Journal of
Financial Economics, vol. 3, October, pp. 305–60.
Shivakumar, L 2013, ‘The role of financial reporting in debt contracting and in stewardship’, Accounting and Business Research,
vol. 43, no. 4, pp. 362–83.
Taylor, P 2013, ‘What do we know about the role of financial reporting in debt contracting and debt covenants?’, Accounting and
Business Research, vol. 43, no. 4, pp. 386–417.
Watts, RL & Zimmerman, JL 1986, Positive accounting theory, Englewood Cliffs, NJ: Prentice Hall.

END NOTES
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University of Rochester.
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   7. Alchian, A 1950, ‘Uncertainty, evolution and economic theory’, Journal of Political Economy, vol. 58, no. 3, pp. 211–21.
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   9. Jensen, M & Meckling, W 1976, ‘Theory of the firm: managerial behaviour, agency costs and ownership structure’, Journal
of Financial Economics, vol. 3, October, pp. 305–60.
 10. ibid.
  11. Godfrey et. al. 2010, op. cit.
  12. Jensen & Meckling 1976, op. cit.

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   13. Smith, CW & Watts, RL 1982, ‘Incentive and tax effects of executive compensation plans’, Australian Journal of
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Research, vol. 43, no. 4, pp. 362–383.

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 81. ibid.
  82. Milligan, E & Winch, S 2012, ‘Power and duty: Is the social contract in medicine still relevant?’, The Conversation, 26 March.
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101. ibid.
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122. Islam, MA, & Deegan, C 2008, ‘Motivations for organization within a developing country to report social responsibility
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135. ibid.
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ACKNOWLEDGEMENTS
Photo: © Stephen Welstead/Getty Images
Photo: © Kritchanut/[Link]
Photo: © chrisdorney/Shutterstock
Figure 5.1: © Figure 2 (p. 69) from Donaldson, T & Preston, LE 1995, ‘The Stakeholder Theory of
the Corporation: Concepts, Evidence and Implications’, From Donaldson, T & Preston, LE 1995,
‘The Stakeholder Theory of the Corporation: Concepts, Evidence and Implications’, Academy of
Management Review, vol. 20, no. 1, pp. 65–91, with permission from the Academy of Management
Academy of Management Review
Article: © Extract from Eleanor Milligan & Sarah Winch, ‘Power and duty: Is the social contract in
medicine still relevant?’, The Conversation
Quote: © BHP Billiton 2014, ‘BHP Billiton sustainability report’, BHP Billiton, Melbourne, p. 3.
Copyright © 2017. Wiley. All rights reserved.

174  Contemporary issues in accounting

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