© 2006 Pearson Education Canada Inc.8-1 Chapter 8 Economic Consequences and Positive Accounting Theory

© 2006 Pearson Education Canada Inc.8-2 Positive Accounting Theory (PAT)

© 2006 Pearson Education Canada Inc.8-3 What is PAT? Studies Managers’ Accounting Policy Choices, As Part of the Overall Process of Corporate Governance That Is, Accounting Policies are Chosen Strategically Positive, Not Normative. Tries to Understand and Predict Managers’ Accounting Policy Choices.

© 2006 Pearson Education Canada Inc.8-4 ASSUMPTIONS OF PAT Managers are Rational (Like Investors)  Conflict (Between Interests of Managers and Investors) Efficient Securities Market Efficient Managerial Labour Market –But may be inside information about manager effort and ability (moral hazard problem) –A second major role for financial reporting-- to report on manager effort and ability

© 2006 Pearson Education Canada Inc.8-5 The 3 Hypotheses of PAT Bonus Plan Hypothesis –Derives from managerial incentive contracts Debt Covenant Hypothesis –Derives from debt contracts Political Cost Hypothesis –Very large firms minimize political “heat” NB: Contacts are Rigid

© 2006 Pearson Education Canada Inc.8-6 Managing Reported Earnings Ways to Do It –Changing accounting policies –Managing discretionary accruals –Timing of adoption of new accounting standards –Changing real variables--R&D, advertising, repairs & maintenance –SPEs (Enron), capitalize operating expenses (WorldCom) –

© 2006 Pearson Education Canada Inc.8-7 Managing Reported Earnings Through Discretionary Accruals NI = OCF ± Net Accruals = OCF ± Net Non-Discretionary Accruals ± Net Discretionary Accruals Examples of Discretionary Accruals –Allowance for doubtful accounts –Provision for reorganization

© 2006 Pearson Education Canada Inc.8-8 Estimating Discretionary Accruals Use Total Accruals as Proxy –Healy (1985) Examine Specific Accounts –Accounts receivable & allowance McNichols & Wilson (1988)

© 2006 Pearson Education Canada Inc Versions of PAT Opportunistic Version –Managers choose accounting policies for their own benefit Efficient Contracting Version –Managers choose accounting policies to attain corporate governance objectives of the firm

© 2006 Pearson Education Canada Inc.8-10 Distinguishing Opportunistic v. Efficiency Versions of PAT, Concl. Conclude: Significant Evidence in Favour of Efficiency Version of PAT This Implies that the Inherent Conflict Between Investor and Manager Interests is Reasonably Controlled –How this is done is subject of Chapter 9