ACCT3003 Issues in Accounting Theory Topic 5 Positive accounting theory

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

Assumption 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

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

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

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

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 principals

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

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

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

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

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

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

Two perspectives adopted by PAT research Efficiency perspective Opportunistic perspective

Efficiency perspective 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

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

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 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

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

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

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

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 Too costly to stipulate all acceptable accounting methods in contract so managers always have some discretionary ability

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