1. ACCT3003 Issues in Accounting Theory
Topic 5
Positive accounting theory

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

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

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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

22. 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