1. Positive Accounting Theory
Chapter 7
Positive Accounting Theory

2. Learning objectives
7.1 Understand how a positive theory differs from a normative theory. 7.2 Be aware of the origins of Positive Accounting Theory (PAT). 7.3 Understand that PAT uses insights from agency theory and why agency theory is of relevance to financial accounting practices. 7.4 Be aware of the central assumptions of PAT. 7.5 Be aware of the meaning and nature of agency costs. 7.6 Understand why an organisation can usefully be referred to as a ‘nexus of contracts’. 7.7 Understand the perceived role of accounting in minimising the transaction costs of an organisation.
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3. Learning objectives (cont.)
7.8 Be aware that accounting policy choices made by management will be influenced by both efficiency considerations as well as opportunistic motivations. 7.9 Be able to identify the reasons for the existence of ‘creative accounting’ Be able to explain the meaning of ‘political costs’ and how accounting can be used to reduce the costs associated with various political processes Understand the role of accounting-based management compensation schemes and debt covenants in reducing potential conflicts (agency costs) within an organisation Understand how particular accounting-based agreements with parties such as debtholders and managers can provide incentives for managers to manipulate accounting numbers.
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4. Learning objectives (cont.)
7.13 Be aware of what constitutes ‘conservative’ accounting procedures and why conservative accounting procedures provide efficient mechanisms for minimising the contracting costs within an organisation Understand the relevance of PAT to current debates about how assets and liabilities should be measured Be able to identify some of the criticisms of PAT.

5. Positive theories compared to normative theories
A positive theory seeks to explain and predict particular phenomena
Positive Accounting Theory (PAT), which we explore in this lecture, is one example of a positive theory of accounting. Other examples are covered in the next lecture (when we consider theories such as Legitimacy Theory and institutional theories which are positive theories that can be applied to explain the practice of accounting)
By contrast, normative theories (which were considered in Chapters 5 and 6) prescribe how a particular practice should be undertaken
the prescription might depart from existing practice

6. 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)
Again, positive theories do not prescribe what should occur – they focus on explaining or predicting what does occur
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7. Positive Accounting Theory defined (cont.)
PAT focuses on relationships between various individuals and explains how accounting is used to assist in the functioning of these relationships
Examples of relationships
between owners and managers
between managers and the firm’s debt providers

8. 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

9. Origins of PAT Started coming to prominence in mid-1960s
paradigm shift from normative theories
PAT became the dominant research paradigm in s and 1980s
shift resulted from US reports on business education, and improved computing facilities enabling large-scale statistical analysis – something common in positive research

10. Origins of PAT—capital markets research
Development of Efficient Markets Hypothesis (EMH) by Fama and others provided an environment suitable for PAT research
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
sought to explain market reactions
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11. 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
But the literature was unable to explain why particular accounting methods were selected – if the market was efficient as commonly assumed by researchers, and could understand how different accounting methods affect accounting numbers, then why does it matter what accounting method was selected? PAT addresses this issue

12. Firms and contracts Firms can be characterised as a nexus of contracts
between consumers of products and the suppliers of factors of production
Firms exist because they reduce contracting costs,
firms provide an efficient means of organising economic activity
[consider the alternative, an individual organising the production of a good: acquiring the raw materials organising various people to make the good]
Contracts include all types of agreements between two or more parties (not necessarily written contracts)

13. Origins of PAT—agency theory
Agency theory was crucial to the development of PAT
Agency theory explained why the selection of particular accounting methods might matter
Focused on the relationships between principals and agents
e.g. between shareholders (principals) and managers (agents)
Information asymmetries create much uncertainty
transaction costs and information costs exist

14. Agency relationship
The ‘agency relationship’ is a central focus of agency theory
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
Agency theory key assumptions from the economics literature, such as:
assumptions of self-interest and wealth maximisation

15. 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

16. The agency problem At the core of the analysis is the ‘agency problem’
The agency problem relates to issues associated with motivating one party (the agent) to work in the best interests of another party (the principal)
Agency problems arise because of inefficiencies and information asymmetries
The agency problem leads to ‘agency costs’

17. 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

18. Role of accounting in contracts
Accounting information is used to address the agency problem and to reduce agency costs
Accounting is used as a monitoring and bonding mechanism to control the efforts of self-interested agents (managers)

19. 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

20. 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

21. 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

22. 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

23. Two perspectives adopted by PAT research
Efficiency perspective
Opportunistic perspective

24. 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 and introduces inefficiencies

25. Opportunistic perspective
Seeks to explain managers’ actions once contracts are already in place
That is, particular accounting methods might initially be selected for efficiency reasons, but once they have been negotiated/agreed, then managers will aim to utilise accounting choices in a way that best serves their own interest
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

26. 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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27. 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

28. 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

29. 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

30. 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

31. Incentives to manipulate accounting numbers
The decision to reward managers on the basis of accounting profits might initially be introduced for efficiency reasons (it motivates them to work in a way that also benefits the principals), but it may subsequently induce them to manipulate accounting numbers (the opportunistic perspective)
a change in accounting numbers 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

32. 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

33. Use of conservative accounting methods in management bonus schemes
Conservative accounting methods, which would include historical cost, tends to delay the recognition of income, accelerate the recognition of expenses, and lead to lower asset and higher liability recognition
Asset and income recognition based on assessments of fair value would not be considered a ‘conservative’ accounting approach
Potential conflicts of interest between agents and principals are better managed when conservative accounting methods are used as they restrict the ability of managers to opportunistically use income and net asset increasing accounting methods

34. Market-based bonus schemes
Apart from accounting-based bonus schemes, managers are also often provided with capital market-based bonuses
May be more appropriate to remunerate managers in terms of market value of firm’s securities (shares) where accounting earnings fluctuate greatly
e.g. mining, or high technology R&D firms
or where managers are approaching retirement
Methods include:
cash bonus based on share price increases
shares
options to buy shares
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35. Market-based bonus schemes (cont.)
Providing managers with shares, or share options creates incentives for managers to increase the value of the firm – aligns their interests with those of the owners (principals)
But, 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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36. Market-based bonus schemes (cont.)
But remember, regardless of how managers are rewarded there is always a maintained assumption within PAT that managers (and everybody else) will be opportunistic
Consider results of Bartov and Mohanram (2004):
In presence of deteriorating profitability managers are likely to adopt income increasing accounting methods to increase share prices and therefore the value of their share options. They would then exercise their share options thereby acquiring the shares, and fairly quickly sell the shares before reported profits ultimately decline and the value of the shares fall
Aboody and Kasnik (2000):
if managers know that share options were to be granted to them they will disclose ‘bad news’ so as to reduce share prices and therefore the likely future exercise price of the share options. This would mean that when they ultimately exercise the granted options, thereby buying the underlying shares, they will pay less and therefore make greater financial gain

37. Choice of accounting versus market-based bonus schemes
Managers’ bonuses are 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

38. Debt contracting—agency costs of debt
Moving our attention to the relationship with debtholders, in the absence of safeguards to protect debtholders (creditors), managers are predicted to adopt strategies to disadvantage the debtholders
Agency costs of debt created by managers 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 (claim dilution)
investment in high-risk projects may not be beneficial to debt holders as they have a fixed claim (asset substitution)
underinvestment

39. Use of debt contracts
In the absence of safeguards to protect the interests of debtholders from strategies such as those on the previous slide, it is assumed the debtholders will require the firm to pay higher costs of interest to compensate for the risks
That is, they will ‘price protect’
If firms contract not to pay excess dividends, take on high levels of debt, invest in risky projects, or under- invest then they can attract debt at lower cost
Hence, it is efficient to enter into contracts that restrict the ability of managers to adversely affect the wealth of debtholders

40. Evidence from 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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41. 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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42. Australian debt contracts (cont.)
Mather and Peirson (2006) provide evidence of a change in the use of covenants relative to earlier periods. Their findings include:
a reduction in the use of debt/asset restrictions;
greater variety of debt convents being used;
more common covenants include minimum interest coverage; minimum dividend coverage; minimum current ratio; minimum required net worth;
use of ‘rolling GAAP’ more common – which introduces risks for the borrower;
mean number of covenants in public debt contracts less than private debt contracts – explained from an efficiency perspective

43. The role of conservative accounting methods in reducing the agency costs of debt
As with management bonus schemes, it is believed that the use of conservative accounting methods are relatively more effective in reducing agency costs of debt
Zhang (2008) suggests that from an efficiency perspective, managers might agree to adopt conservative accounting methods because it allows them to attract debt at a lower price
The use of conservative accounting procedures means that debt covenants restricting the amount of debt relative to assets (or debt to equity), or the amount of times profits must cover interest (known as an ‘interest coverage’ clause), will tend to be more restrictive or binding compared to those organisations that do not adopt conservative accounting methods.
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44. The role of conservative accounting methods in reducing the agency costs of debt (cont)
As Zhang (2008) argues, the more binding covenants will provide an earlier warning of default risk, and will thereby reduce the risk exposure of the lending party (for example, a bank)
The reason for this is that, because management will have less ability to circumvent restrictive covenants (for example, by undertaking asset revaluations), such covenants will create a technical default of a loan agreement earlier than if management has the scope to loosen the restrictions
The earlier the lender can take action to safeguard its funds, the lower the risk to the lender

45. Debt contracts—manager’s incentive to manipulate
Ex post, the incentive to manipulate accounting numbers increases as the accounting-based debt covenants 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
But as we have learned, contracts that require the use of conservative accounting methods reduce the ability of managers to opportunistically manipulate accounting numbers

46. 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

47. Political costs
We have already indicated that financial accounting numbers are important with respect to debt contracting and management compensation contracting. Financial accounting also plays a key role in the political process
Political costs are 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

48. 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

49. Actions of politicians
Politicians know that highly profitable companies could be unpopular with members of their constituency
Politicians (who are assumed to be driven by self- interest like everybody else) could win votes by taking actions against the companies
argue that it is in public interest even though in own interest
May rely on reported profits to justify actions
provides incentives for firms to reduce reported profits

50. Example of how politicians use accounting numbers as a means of justifying actions against an organisation
As reported in the Hobart Mercury on 9 March 2013, the Australian Greens political party used the size of bank assets and profits as the basis for levying additional taxes on banks. The article stated:
The Greens want a levy of 0.2 per cent on all bank assets above $100 billion in return for Federal Government guarantees, which the independent Parliamentary Budget Office has costed as raising $11 billion over the next four years.
“At a time when there's pressures on the budget, and the government is looking around for ways of raising revenue, especially in light of the failed mining tax, who can afford to pay it the most?" Australian Greens’ Mr Bandt said yesterday.
"If we don't stand up to the big banks and the big miners, then the Labor Party is going to come after the rest of us, like they have with single parents, and like they are threatening with the forthcoming budget."
As we can see, ‘profits’ are used to justify the proposed action. Lower reported profits would provide less ‘ammunition’ for the politicians

51. Relevance of PAT-based research to current efforts of IASB to promote use of fair values
As already indicated in this lecture, conservative accounting methods lead to:
relatively lower revenue recognition
faster expense recognition
higher liability recognition
lower asset recognition
Historical cost accounting is a conservative approach to accounting when compared to fair value accounting
Conservative accounting methods, such as historical costs, reduce the ability of managers to manipulate accounting numbers compared to fair value accounting
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52. Relevance of PAT-based research to current efforts of IASB to promote use of fair values (cont)
Do the ongoing efforts of the IASB to embrace fair values make sense from an efficient contracting perspective?
Because conservative accounting methods reduce the possibility that management will undertake opportunistic earnings management, organisations that use conservative accounting methods might be able to attract debt and equity capital at a lower cost because of perceptions about lower risk
Applying this reasoning, numerous researchers argue that the IASB and FASB should take note of the advantages inherent in conservative accounting procedures before finalising any judgements about accounting measurement
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53. Relevance of PAT-based research to current efforts of IASB to promote the use of fair values (cont)
Whilst information about fair values will be useful to various financial stakeholders in terms of assisting them to make informed investment/resource allocation decisions, more conservative accounting methods also provide benefits in terms of controlling potentially divergent behaviour of individuals involved in various contractual arrangements.
There is a clear-trade-off between the advantages of having relevant information about current values and the contracting benefits that more conservative accounting benefits provide

54. 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

55. Diagrammatic summary of PAT