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PPTs t/a Deegan, Financial Accounting Theory 3e
Financial Accounting Theory
Craig Deegan
Chapter 7
Positive accounting theory
Slides written by Craig Deegan
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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
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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

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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)
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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
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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
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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
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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

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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
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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
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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
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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
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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
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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
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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
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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
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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
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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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PPTs t/a Deegan, Financial Accounting Theory 3e
Two perspectives adopted by PAT
research
Efficiency perspective

Opportunistic perspective
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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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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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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
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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
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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
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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
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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
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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
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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
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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
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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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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
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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
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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
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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
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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

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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
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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
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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
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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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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
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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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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