1. Financial Accounting Theory Craig Deegan
Chapter 7
Positive accounting theory
Slides written by Craig Deegan and Michaela Rankin
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2. 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
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3. 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
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4. 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)
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5. 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
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6. 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
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7. 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
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8. 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
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9. 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
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10. 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
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11. 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
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12. 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
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13. 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
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14. 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
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15. 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
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16. 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
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17. 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
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18. 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
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19. Two perspectives adopted by PAT research
Efficiency perspective
Opportunistic perspective
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20. 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
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21. 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
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22. 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
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23. 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
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24. 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
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25. 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
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26. 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
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27. 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
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28. 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
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29. 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
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30. 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
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31. 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
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32. 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
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33. 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
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34. 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
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35. 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
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36. 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
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37. 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
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38. 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
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39. 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
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40. 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
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41. 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
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