Financial Accounting Theory Craig Deegan Chapter 7 Positive accounting theory Slides written by Craig Deegan and Michaela Rankin Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

Learning objectives In this chapter you will be introduced to how a positive theory differs from a normative theory the origins of Positive Accounting Theory (PAT) the perceived role of accounting in minimising the transaction costs of an organisation how accounting can be used to reduce the costs associated with various political processes how particular accounting-based agreements with parties such as debtholders and managers can provide incentives for managers to manipulate accounting numbers some criticisms of PAT Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

Positive compared to normative theories A positive theory seeks to explain and predict particular phenomena Normative theories prescribe how a particular practice should be undertaken the prescription might depart from existing practice Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

Positive Accounting Theory defined PAT ‘… is concerned with explaining accounting practice. It is designed to explain and predict which firms will and which firms will not use a particular method … but it says nothing as to which method a firm should use.’ (Watts and Zimmerman 1986, p. 7) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

Positive accounting theory defined (cont.) Focuses on relationships between various individuals and how accounting is used to assist in the functioning of these relationships Examples of relationships owners and managers managers and the firm’s debt providers Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

Assumptions underlying PAT All individuals’ action is driven by self-interest and individuals will act in an opportunistic manner to the extent that the actions will increase their wealth does not incorporate notions of loyalty or morality Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

Origins of PAT Started coming to prominence in mid-1960s paradigm shift from normative theories dominant research paradigm in 1970s and 1980s shift resulted from US reports on business education, and improved computing facilities enabling large-scale statistical analysis Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

Origins of PAT—capital markets research Development of Efficient Markets Hypothesis (EMH) by Fama and others capital markets react in an efficient and unbiased manner to publicly available information Ball and Brown (1968) paper was crucial to the acceptance of the positive research paradigm investigated stock market reaction to accounting earnings announcements Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

Origins of PAT—capital markets research (cont.) Price of a security based on beliefs about present value of future cash flows Ball and Brown found that earnings announcements impacted share prices evidence that historical cost information is useful to the market Literature unable to explain why particular accounting methods selected Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

Origins of PAT—Agency theory Explained why the selection of particular accounting methods might matter Focused on the relationships between principals and agents e.g. shareholders and managers Information asymmetries create much uncertainty transaction costs and information costs exist Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

Agency relationship Defined by Jensen and Meckling (1976) ‘a contract under which one or more (principals) engage another person (the agent) to perform some service on their behalf which involves delegating some decision-making authority to the agent’ Relies on traditional economics literature assumptions of self-interest and wealth maximisation Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

Price protection In the absence of contractual mechanisms to restrict agents’ potentially opportunistic behaviour the principal will pay the agent a lower salary compensates principals for adverse actions Agents will therefore have incentives to enter contracts which appear to limit actions detrimental to agents Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

Agency costs Monitoring costs Bonding costs Residual loss costs of monitoring agents’ behaviour e.g. auditing financial statements Bonding costs costs involved in agents bonding their behaviour to expectations of principals e.g. preparing financial statements Residual loss too costly to remove all opportunistic behaviour Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

Role of accounting in contracts Accounting information used to reduce agency costs Used as monitoring and bonding mechanisms to control the efforts of self-interested agents Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

Key hypotheses Three key hypotheses frequently used in PAT literature to explain and predict support or opposition to an accounting method bonus plan hypothesis debt hypothesis political cost hypothesis Research assumes managers will act opportunistically when selecting methods Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

Bonus plan hypothesis Managers of firms with bonus plans are more likely to use accounting methods that increase current period reported income also called management compensation hypothesis action increases the present value of bonuses paid to management Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

Debt hypothesis The higher the firm’s debt/equity ratio, the more likely managers use accounting methods that increase income also called debt/equity hypothesis the higher the debt/equity ratio, the closer the firm is to the constraints in debt covenants covenant violation results in costs of technical default Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

Political cost hypothesis Large firms rather than small firms are more likely to use accounting choices that reduce reported profits size is a proxy variable for political attention reduction of reported income is hypothesised to reduce the possibility that people will argue that the organisation is exploiting other parties Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

Two perspectives adopted by PAT research Efficiency perspective Opportunistic perspective Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

Efficiency perspective Researchers explain how contracting mechanisms minimise agency costs of the firm Known as ex ante perspective mechanisms put in place up front to minimise future agency and contracting costs Managers select accounting methods which most efficiently reflect underlying firm performance PAT theorists argue that regulation forcing firms to use a particular accounting method imposes unwarranted costs Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

Opportunistic perspective Seeks to explain managers’ actions once contracts are already in place Not possible to write complete contracts, so managers are assumed to opportunistically act to maximise own wealth Known as ex post perspective considers opportunistic actions after the fact Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

Owner/manager contracting Assuming self-interest, owners expect managers (agent) to undertake activities not always in the interest of owners (principal) Managers have access to information not always available to principals information asymmetry further increases managers’ ability to undertake activities beneficial to themselves Costs of divergent behaviour are agency costs Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

Owner/manager contracting (cont.) In the absence of controls to reduce opportunistic behaviour, agents (managers) expected to undertake activities disadvantageous to the value of the firm Principals price this into the amounts they are prepared to pay the manager Managers may contract themselves not to consume perks so will receive higher salary known as bonding Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

Methods of rewarding managers Fixed basis—salary independent of performance manager may not take great risks as does not share in potential gains Salary plus remuneration is, in part, tied to firm performance known as bonus schemes Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

Bonus schemes Remuneration can be tied to profits of the firm sales of the firm return on assets All based on output from the accounting system May also be rewarded in line with market price of the firm’s shares Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

Accounting-based bonus plans Any changes in accounting methods will affect the bonuses paid may occur as a result of a new accounting standard in place Contracts in some circumstances may be based on the old method in place so changes will not affect bonuses Contracts relying on accounting numbers may rely on ‘floating’ GAAP Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

Incentives to manipulate accounting numbers Rewarding managers on the basis of accounting profits may induce them to manipulate accounting numbers (the opportunistic perspective) will affect their rewards Bonuses based on profits cause short-term rather than long-term focus may affect investment in positive NPV projects if returns not expected to be consistent Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

Incentives to manipulate accounting numbers—evidence Healy (1985) found managers adopt accounting methods to maximise bonus if contract rewarded managers after a pre-specified level of earnings reached if income not expected to reach pre-specified minimum, managers shift earnings to future period (‘take a bath’) Lewellen, Loderer and Martin (1987) found US managers approaching retirement are less likely to undertake R&D expenditure if rewards based on accounting-based performance measures short-term focus Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

Market-based bonus schemes May be more appropriate to remunerate managers in terms of market value where accounting earnings fluctuate greatly e.g. mining, or high technology R&D firms Methods include cash bonus based on share price increases shares options to shares Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

Market-based bonus schemes (cont.) Managers have incentives to increase the value of the firm Problems include share price also affected by factors beyond the control of managers (e.g. general market movements) only senior managers likely to have a significant impact on share value Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

Choice of accounting versus market-based bonus schemes More likely to be based on accounting earnings where share returns relatively more sensitive to general market movements earnings have a high association with firm-specific movement in the firm’s share values earnings have a less positive association with market-wide movements in equity values Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

Debt contracting—agency costs of debt Agency costs of debt include excessive dividend payments, which leave fewer assets to service debt the organisation may take on additional debt, with new debtholders competing with original debtholders for repayment investment in high-risk projects may not be beneficial to debt holders as they have a fixed claim Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

Use of debt contracts In the absence of safeguards to protect the interests of debtholders, it is assumed they will require the firm to pay higher costs of interest to compensate If firms contract not to pay excess dividends, take on high levels of debt or invest in risky projects, then they can attract debt at lower cost Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

Australian debt contracts In relation to Australian debt contracts, Cotter (1998) found leverage covenants frequently used in bank loan contracts leverage most frequently measured as the ratio of total liabilities to total tangible assets prior charges covenants typically included in term loan agreements of larger firms prior charges covenants defined as a percentage of total tangible assets Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

Australian debt contracts (cont.) debt to assets, interest coverage and current ratio clauses frequently in use interest coverage required to be between 1½ and 4 times current ratio clauses required current assets be between 1 and 2 times the size of current liabilities Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

Debt contracts—manager’s incentive to manipulate Ex post, the incentive to manipulate numbers increases as the constraints approach violation Managers found to manipulate accounting accruals in the years before and the year after violation of a debt agreement Consider HIH Too costly to stipulate all acceptable accounting methods in contract so managers always have some discretionary ability Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

Role of external auditors Auditors arbitrate on the reasonableness of the accounting method chosen Demand for financial statement auditing when management is rewarded on the basis of numbers generated by the accounting system the firm has borrowed funds, and accounting-based covenants are in place to protect the investment of debtholders Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

Political costs Costs resulting from political attention from government, lobby groups etc. Commonly directed at larger firms indication of market power May result in increased taxes, increased wage claims, product boycotts etc. Firms likely to adopt accounting methods to reduce profits to lower political scrutiny Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

Political actions of individuals Limited expected ‘pay-off’ results from the actions of individuals Results in formation of interest groups Information costs shared, ability to investigate government and business action increases Given self-interest, representatives of interest groups predicted to maximise own welfare as constituents have limited motivation or means to be fully informed Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

Actions of politicians Politicians know that highly profitable companies could be unpopular with members of constituency Politicians could win votes by taking actions against the companies argue that in public interest even though in own interest May rely on reported profits to justify actions provides incentives for firms to reduce reported profits Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

Criticisms of PAT Does not provide prescription PAT is not value-free as it asserts assumption that all action is driven by self-interest Argued to be too negative and simplistic a perspective of humankind Issues have not shown great development In undertaking large-scale empirical research, researchers ignore organisational-specific relationships Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan