Early research considering share price reactions to accounting information relied on various assumptions about the efficiency of the capital market and assumed that capital market participants could ‘undo’ the effects of organisations using different accounting methods. It also assumed the absence of transaction costs. Accepting these assumptions, and to the extent that the selection of accounting method did not affect taxation, then the choice of accounting method would have limited implications for the firm and hence managers should be indifferent when choosing between alternative accounting methods. However, evidence indicates that managers are not indifferent.

The development of agency theory suggested that where there is a delegation of decision making within an organisation there can be inefficiencies because agents will not necessarily work in the interests of the organisation, but rather will work in their own interests. However, the principals will anticipate the opportunistic actions of the agents and will reduce their payments accordingly (that is, the principals will price protect). To minimise the agency costs, and to align the interests of principles and agents, numerous contractual arrangements will be put in place.
Accepting the perspectives provided by Agency Theory, Watts and Zimmerman (1978) showed how accounting-based contractual arrangements can act to minimise the transaction costs that might arise within an organisation. The choice of one method of