AF301

Topic 7
Positive Accounting Theory (PAT)
Overview of PAT
Positive Theories
 Explain and Predict
 Without value/moral/ethical judgement
 In particular, PAT predicts the type of accounting
policies that firms are likely to choose e.g. are
they likely to adopt policies that increase or
decrease reporting earnings
 Learning Outcomes
On successful completion of this unit, you should be able to:
1.Outline Agency Theory and explain the source of
conflict between principals and agents
2.Explain agency costs [monitoring, bonding & residual
loss]
3.Discuss 3 agency problems associated with equity
4.Discuss 4 agency problems associated with debt
5.Describe earnings management
6.Discuss the bonus plan hypothesis
7.Discuss the debt hypothesis
8.Discuss the political cost hypothesis
LO 1

AGENCY THEORY
Agency Theory

Managers
Agency Theory
Principals appoint agents to manage resources and make
decisions on their behalf
 Due to constraints on time, expertise etc. e.g.
principals have finance but may lack managerial skills
 Both groups are assumed to be self-interested. This
may lead to conflict due to:
 Divergence (non-alignment) of interests; and
 Information asymmetry
2 main scenarios
 Managers and Shareholders
 Managers/Shareholders and Debt-holders
Self-interest & Wealth Transfer
Agents may seek to transfer wealth away from the
principal
 to themselves
Examples
1.Manager buying an expensive official car, when
she could do with a basic (cheaper) model
2.Employees using company time & resources for
personal benefit
LO 2

AGENCY COSTS

Monitoring,
Bonding
Residual Loss
Monitoring
This is initiated by the principal
e.g. major capital expenditure projects must be
approved by the board (Shareholders’
representatives) which also reviews progress of the
project and performance against plan
Price Protection
 Managers with `poor’ reputation will be subjected to
greater monitoring
 Agents build the monitoring costs into the manager’s
compensation e.g. reduced salary
 Ex-ante (in advance) or ex-post (after
performance is known
Bonding
This is initiated by the agent e.g.
 voluntary disclosure (beyond what is required by IFRS,
Companies Act etc.)
 shareholder `engagement’ e.g. company roadshows
Bonding is costly for managers
 involves their time and effort
 constrains their opportunity for wealth transfer by
disclosing performance
Managers will bond to the extent that
 marginal benefit (e.g. salary protection) exceeds
 marginal cost of bonding (their own time and effort)
Residual Loss
Agent’s self-interest can be reduced through
 Monitoring; and
 Bonding
However it is unlikely to be totally eliminated

Some loss (residual loss) remains because:

 of imperfect information (principals don’t know
everything that agents do); and
 it’s uneconomical to conduct 100% surveillance
LO 3

AGENCY PROBLEMS OF EQUITY

Conflict between shareholders and

managers based on assumption of
self-interest or rational wealth
maximisation
1. Dividend Retention Problem
Consider this scenario
A firm has investment projects with a return of 10% but
shareholders can invest elsewhere for a return of 15%
 Logically, shareholders would prefer to receive cash
fro the firm (through dividends) which they can re-
invest elsewhere for higher returns
 However managers prefer to retain cash so they can:
 fund their own salaries & benefits (perquisites)
 Increase the size of the firm and consequently the
scope of their own power (empire building)
 Thus managers may recommend lower dividends
which is contrary to shareholders’ preference
 2. Risk Aversion Problem
Consider this scenario
A firm is presented with an investment project involving a
new product/market etc. The project offers a rate of
return above the required benchmark.
 Shareholders have diversified investment portfolios
 Because they can invest their funds in various
securities at the same time
 They seek high-risk projects with high returns
 However managers can’t diversify their job risk
 Seek to protect their job, remuneration & reputation
 Thus managers may reject high-risk projects,
contrary to shareholders’ preference
3. Horizon Problem
Consider this scenario
A manager will be retiring in the next 2 years.
 In general, shareholders would prefer sustainable
returns over the long- term (remember that shares
have an indefinite life)
 However the manager may not be interested in
returns after her retirement (or beyond her current
contract) because they will not affect her
 Younger managers may not wish to make a long-
term commitment to 1 job
 Thus they focus on projects with high short-term
returns contrary to shareholders’ preferences
Monitoring these Issues
Shareholders are well-aware of these three problems.
To mitigate against the problems, shareholders can
institute performance contracts
 using accounting based ratios
e.g. Managers may be offered bonuses, based on
certain ratios
1.Dividend Payout Ratio must be more than x%. This
mitigates against dividend retention
2.Profitability Ratios (Short-term) must exceed y%.
This encourages managers to take risk.
3.Share Price (Long-term) must grow by z cents. This
focuses on long-term performance.…
AGENCY PROBLEMS OF DEBT

Conflict between lenders and

managers based on assumption of
self-interest or rational wealth
maximisation
LO 4

1. Excessive Dividends Problem

Since managers are appointed by shareholders
 They are expected to prioritise shareholders’
interests over lenders

Lenders prefer firms to retain cash for loan repayment

 However managers may prioritise dividends to
shareholders
 Thereby reducing capacity for loan repayments
 This is contrary to lenders’ preferences
2. Claim Dilution Problem
Consider this scenario
A firm has taken a loan from Bank X.
 However the firm subsequently takes a loan from
Bank Y and gives Bank Y first charge (priority) over
its assets
Bank Y now has first charge over the firm’s assets
 Thus the priority of Bank X’s claim has been
reduced (diluted or made weaker)
 Clearly, this is not in the lenders’ best interest
3. Asset Substitution Problem
Consider this scenario
A firm received a loan from Bank Z, based on its existing
assets and risk profile.
 However, after receiving the loan, the firm took on
projects with a higher risk profile
Bank Z will be concerned that their lending rate fails to
cover the risk involved in new projects
 The firm’s actions are not in the best interest of Z.
 Had Z known the firm’s true intentions, it would have
increased the risk premium (ex-ante price-protection)
i.e. charged a higher interest rate on the loan
4. Under-investment Problem
Note: This only applies in the
Consider this scenario context of financial distress

A firm is in financial distress i.e. facing bankruptcy.

It has a potential investment project with a positive
NPV i.e. the project is viable.
 Lenders would prefer the firm to accept the
project, because it can generate cash flows to
repay them
 However managers may reject the project
knowing the cash flows will go to lenders (not
shareholders)
 This action is contrary to lenders’ preferences
Monitoring these Issues
Lenders are aware of these problems.
 To mitigate them, they can institute contracts, with
debt covenants using accounting based ratios
Here are some examples
1. Dividend Payout Ratio cannot exceed a%. This is
designed to deter excessive dividends.
2. Our debt ranks first. Debt ratio cannot exceed b%
3. This loan is secured over Asset(s) A, B, C etc.
4. Upon breach of the above terms, we will
 fore-close
 appoint a receiver etc.
 SUMMARY

Agency Problems of Equity & Debt

Shareholder-Manager Conflict
Problem Nature of the Conflict
Dividend Shareholders would prefer cash which they
Retention can re-invest elsewhere, but managers
retain cash to fund their benefits & build
empires.
Risk Shareholders prefer high-risk projects with
Aversion high returns, but managers seek to safe-
guard their job prospects. Shareholders
also have limited liability.
Horizon Shareholders prefer sustainable long- term
Problem returns, but managers may prefer projects
that deliver high returns in the short-term
only.
Manager-Debtholder Conflict
Problem Nature of the Conflict
Excessive Lenders prefer firms to retain cash for
Dividends loan repayment, but managers may
prioritise dividends to shareholders.
Claim Existing lenders prefer higher priority for
Dilution their loan, but managers may agree to
rank new lenders first.
Asset Existing lenders may have funded a
Substitution particular project, but managers could
use the funds for higher-risk projects.
Under- In financially distressed firms, managers
investment may reject projects with positive NPV
LO 5

EARNINGS MANAGEMENT
Earnings Management
This occurs when managers influence or manipulate
reported income
 To achieve a desired outcome e.g. target profit
 When firms fail to achieve their target profit,
managers may lose bonuses and investors may
lose confidence (leading share prices to fall)
Income Smoothing
 This occurs when managers seek to produce a
‘smooth’ profit line, rather than a volatile or
fluctuating one. Smooth profits may imply steady
or consistent growth.
Methods of Earnings Management
Discretionary Relate to depreciation, COGS, doubtful
Accruals debts, inventory obsolescence,
warranties
e.g. adopting a lower % for doubtful
debts will increase reported profit
Timing of e.g. suppose a firm expects to make a
Transactions gain from selling a particular vehicle
It can deliberately schedule the sale to
affect reported income
If it has already met its profit target, it
may defer the sale to next year. If it
hasn’t met the target, it may sell now
(to achieve this year’s target)
LO 5

Detecting Earnings Management

1. Conduct multiple regression for all firms, including:
 Discretionary accruals as the dependent variable
 PP&E (indicator of depreciation) x1
 Credit Sales (indicator of doubtful debts) x2
 Inventory (indicator of obsolescence) x3
2. Obtain a model for expected accruals in the format y
= ax1 + bx2 +cx3 etc.
3.Enter firm level data (for the independent variables
x1, x2, x3 above ) into the model
4.Compare expected and actual accruals for the firm
 The difference represents likely earnings
management
LO 6

BONUS PLAN HYPOTHESIS

Managers may be entitled to

bonuses for exceeding certain
targets.
Bonus-Plan Hypothesis
This hypothesis states:
“Firms with management compensation plans use profit-
increasing accounting policies”
Generally, managers who are entitled to profit-based
bonuses choose accounting policies that increase
reported earnings
 to maximise their own bonuses (extracting wealth);
by:
 recording lower discretionary accruals for COGS,
depreciation, doubtful debts, inventory
obsolescence etc.
Bonus-Plan Hypothesis
This applies within boundaries, based on profit targets
Consider CEO who is entitled to a 1% bonus if profit
exceeds $2M. The bonus is capped (e.g. no further bonus
for CEO if profit exceeds $5m)
If underlying Profit is Expected accruals by CEO
Just below lower limit Income-increasing, i.e. transfer
for bonus e.g. $1.9M more income to this year to
help meet current target
Above upper limit Income-decreasing, i.e. transfer
(cap) e.g. $5.2M income to next year, helping to
achieve future targets
Far below lower limit Income-decreasing, i.e. pass all
e.g. $0.8M write-offs this year (take a bath)
Management Compensation
Firms can provide bonuses in various ways
1. Cash
 However cash rewards are not closely linked to the
firm’s share price and dividends
 So this may encourage earnings management
2. Shares
 Align managers’ and shareholders’ interests
 As shareholders, managers are motivated to
implement strategies that will improve underlying
profitability
 But this may aggravate managers’ risk aversion by
exposing them to downside risk if share price drops
Management Compensation
3. Share Options
 This will protect managers from downside risk
 Managers will only exercise options if the share
price appreciates. Otherwise the options lapse.
e.g. A company issues options to CEO when the share
price = $2.00
 They can be exercised for $3 (target) in 2 to 3 years
from now (enough time to implement strategies)
 If the share price exceeds $3.00 the CEO will
exercise her options (purchase at a discount
compared to the market price) AND shareholders
benefit from a capital gain
LO 7

DEBT HYPOTHESIS
Debt Hypothesis
This hypothesis states:
“As a firm’s leverage increases, the manager selects
accounting procedures that shift reported profits
from future periods to present periods”
Consider the debt/equity ratio (a leverage ratio)
 Debt Equity Ratio = Debt/Equity
By increasing reported earnings, a firm is able to
 reduce the D/E ratio; and
 avoid breaching debt covenants (see calculation
on next slide)
Debt Hypothesis
Before earnings After increasing
management profit by 50
Debt $100M $100M
Equity $200M $200M
+ $50M
= $250M
D/E Ratio 100/200 x 100 100/250 x 100
= 50% = 40%
LO 8

POLITICAL COST HYPOTHESIS

Political Costs
Government has the power to re-allocate wealth,
through:
1. Taxes (which reduce wealth of target groups)
2. Subsidies (which increase wealth of target
groups)
Various interest groups will lobby government to act in
their best interest
 e.g. industries may lobby for subsidies to reduce
their costs while environmentalists may lobby for
taxes on polluting firms
Political Cost Hypothesis
This hypothesis states:
“The larger (more visible) the firm, the more likely the
manager is to choose accounting policies that reduce
reported profits.”
e.g. if a commercial bank announces high profits,
employees may seek higher wages and customers
may seek reduced bank charges and/or interest rates
Thus firms reduce reported earnings to
 Prevent wealth extraction through donations,
claims from trade unions, price reductions etc; &
 Avoid withdrawal of government subsidies etc.
 AF301

Topic 7
Positive Accounting Theory (PAT)