Tutorial 5

Question 1
(a) Key hypothesis
Developed from PAT, it proposes that managers on accounting-based bonus schemes
will select accounting methods that lead to an increase in profits.

Hypothesis predicts that: Managers of firms with bonus plans are more likely to use
accounting methods that increase current period reported income.

This is because the choice of accounting chosen increases the present value of
bonuses paid to management.

(b) In the efficiency perspective and opportunistic perspective

Managers are often rewarded in terms of accounting-based bonus plans. Such plans
are introduced to align the interests of the managers of the firm with those of the
owners. The establishment of management bonus plans can be explained from an
efficiency perspective.

Subsequent after the bonus plan established, managers who are rewarded in bonus
(bonus which relates to accounting numbers) are more likely to select accounting
methods that increase in the size of the bonus. This is an opportunistic perspective.

Question 2
(a) Conservative accounting methods: tend to delay the recognition of revenue, accelerate
the recognition of expenses, and tend to lead to lower asset and higher liability
recognition. For example, measuring assets at lower of cost (or recoverable amount)
and not fair value. This means that increases in fair value would not be recognised
(keeping asset values lower), but if there is a decrease in value then a reduction in
assets, and a consequent expense, would be recognised.

The use if fair values is more subjective. The use of fair values provides management
with discretion in determining fair values, particularly, if the values are determined by
use of a valuation model rather than on the basis of quoted prices in active markets.

(b) The senior managers

Generally speaking, managers rewarded by way of accounting-based bonus plans
would be expected to oppose conservative accounting methods, as such methods
would tend to delay income recognition and would also tend to reduce the ability of
managers to be able to use their own discretion with respect to measuring assets and
liabilities, as well as income and expenses. That is, conservative accounting methods
reduce the ability of managers to be opportunistic so that they are being monitored in
select accounting methods that increase income to the extent that this will lead to an
increase in the size of the bonus.
 The organisations (owners/shareholders)
By contract, owners/shareholders who are not directly involved in the management of
an organization would prefer that conservative accounting methods are used.
Conservative accounting methods reduce the possibility that management will
undertake opportunistic earnings and asset management, and this will tend to increase
the efficiency with which owners (equity holders) and debtholders can monitor the
activities of managers. This in turn will reduce the risks inherent in the investments
held in the organization. The consequence of this is that organisations that use
conservative accounting methods might be able to attract debt and equity capital at a
lower cost because of perceptions of lower risk.

In conclusion
Managers who are being rewarded by way of accounting-based bonus schemes would
be expected to oppose the use of conservative accounting methods whereas owners
would prefer the use of conservative accounting methods as it will enable them to
more efficiently monitor the actions of the managers.

Question 3
(a) It is p43dicted by Positive Accounting Theory (PAT) that on an ex ante interests of
the managers) agents with those of the owners (as principals). Eg. This include
offering management with a bonus plan which is tied to reported profits. Such
mechanisms will lead to reduction in agency costs (they will encourage the self-
interested manager to work harder) and so can be explained from an efficiency
perspective.

However, it is assumed that once a profit-sharing bonus scheme is put in place as

mentioned above, then management will seek to undertake actions to increase the size
of the bonus and hence their own financial rewards. One way is to work harder, but
another way is to manipulate reported profits by selecting accounting methods that
lead to an increase in reported profits (the opportunistic perspective).

So we can conclude that if a manager is paid a percentage profit (eg. a bonus plan),
under bonus plan hypothesis, we expect the manager will be motivated to manipulate
profits (due to the assumption of self-interest positive accounting theory).

(b) Within PAT it is assumed that principals expect managers to be opportunistic and
unless managers can demonstrate that they have not been opportunistic, accordingly
the principal will pay the managers a lower salary (this is called ‘price protection’).
The lower salary compensates the principals for the expected opportunistic behavior
of the agents.

To reduce the managers’ ability to be opportunistic (with consequent implications for

increasing the managers’ bonuses), the contractual agreements will be put in place
upfront to reduce the ability of the managers to manipulate accounting profits.
 Such agreements may include a clause which restricts the choice of management has
when selecting between alternative accounting methods or it may include a
requirement that the financial statements be audited by an independent third party
who will attest to whether appropriate accounting methods have been selected by the
maneger.

Question 4
Conservative accounting policies are those methods that tend to delay the recognition of
revenue, accelerate the recognition of revenue, accelerate the recognition of expenses, and
tend to lead to lower asset and higher liability recognition.
For example, measuring assets at lower of cost (or recoverable amount) and not fair value.
This means that increases in fair value would not be recognised (keeping asset values lower),
but if there is a decrease in value then a reduction in assets, and a consequent expense, would
be recognised.
The use of fair values is more subjective. The use of fair values provides management with
some discretion in determining by use of a valuation model rather than on the basis of quoted
prices in active markets.

Conservative accounting – bonus plan contracting

One explanation for why firms might choose to implement conservative accounting practices
lies in efficient contracting theory, i.e. conservative accounting can be used as part of a firm’s
strategy to mitigate the conflicts that arise among the many claimants of a firm’s net assets.
This is due to the fact that conservative accounting methods place constraints on the
distribution of those net assets thereby limiting the scope for self-serving opportunistic
behavior.

As reflected in the above quote, because conservative accounting methods can 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.