Issues in Accounting and

Accountability

3. Positive Accounting Theory

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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

 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 firm’s debt providers

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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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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

 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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Origins of PAT—capital markets research—continued

 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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Origins of PAT—
Agency theory

 Explained why the selection of particular accounting

methods might matter

 focused on the relationships between principals and agents

 eg. shareholders and managers

 information asymmetries create much uncertainty

 transaction costs and information costs exist

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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’

 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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Agency costs

 Monitoring costs
 costs of monitoring agents behaviour
 eg. auditing financial statements

 Bonding costs
 costs involved in agents bonding their behaviour to
expectations of principals
 eg. preparing financial statements

 Residual loss
 too costly to remove all opportunistic behaviour

 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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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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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

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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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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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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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Owner / manager
contracting—continued

 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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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

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Incentives to manipulate accounting numbers—evidence

 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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Market-based bonus schemes

 May be more appropriate to remunerate managers in terms

of market value where accounting earnings fluctuate greatly
 eg. mining, high technology R&D firms

 Methods include: cash bonus based on share price

increases, shares, options to shares

 Managers have incentives to increase the value of the firm

 Problems include:
 share price also affected by factors beyond the control
of managers, eg. general market movements
 only senior managers likely to have a significant impact
on share value

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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

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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

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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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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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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

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