Positive Accounting 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. Accounting can be used to reduce the costs associated with various political processes.
Positive Accounting 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. Accounting can be used to reduce the costs associated with various political processes.
Positive Accounting 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. Accounting can be used to reduce the costs associated with various political processes.
PPTs t/a Deegan, Financial Accounting Theory 3e Financial Accounting Theory Craig Deegan Chapter 7 Positive accounting theory Slides written by Craig Deegan 7-2 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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 7-3 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Positive 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 the practice of accounting)
By contrast, normative theories prescribe how a particular practice should be undertaken the prescription might depart from existing practice
7-4 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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) 7-5 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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 firms debt providers 7-6 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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 7-7 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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 something common in positive research 7-8 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Origins of PATcapital 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
7-9 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Origins of PATcapital 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 7-10 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Origins of PATAgency 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 7-11 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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 7-12 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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 7-13 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Agency costs Monitoring costs 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 7-14 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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 7-15 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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 7-16 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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 7-17 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Debt hypothesis The higher the firms 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 7-18 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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 7-19 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Two perspectives adopted by PAT research Efficiency perspective
Opportunistic perspective 7-20 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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 7-21 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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 7-22 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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 7-23 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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 7-24 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Methods of rewarding managers Fixed basissalary 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 7-25 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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 firms shares 7-26 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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 7-27 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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 7-28 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Incentives to manipulate accounting numbersevidence 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 7-29 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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 7-30 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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 7-31 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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 firms share values earnings have a less positive association with market- wide movements in equity values 7-32 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Debt contractingagency 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 7-33 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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 7-34 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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 7-35 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Australian debt contracts (cont.) debt to assets, interest coverage and current ratio clauses frequently in use interest coverage required to be between 1 and 4 times current ratio clauses required current assets be between 1 and 2 times the size of current liabilities
7-36 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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 that private debt contracts explained from an efficiency perspective 7-37 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Debt contractsmanagers 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 7-38 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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 7-39 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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 7-40 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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 7-41 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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 7-42 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 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