Positive Accounting Theory

Positive Accounting TheoryWhat is Positive Accounting
Theory (PAT)?
• PAT is one of many positive theories of accounting (A positive theory
seeks to explain and predict particular phenomena)
• PAT seeks to explain why managers within organisations elect to
adopt particular accounting methods in preference to others. (It does
not tell what accounting methods should be undertaken by managers
of an organisation.)
• 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)
• In financial accounting, managers have a choice between alternative
accounting methods to account for a particular transaction or event.
PAT explain why managers will adopt or support a particular
accounting method when confronted with a choice between
alternative method
Overview of PAT
Overview of PAT
Source: Deegan. C, 2012, Financial
Source: Deegan. C, 2012, FinancialAccounting Theory, McGraw Hill, MelbourneAccounting Theory, McGraw Hill, Melbourne
What are the assumption
What are the assumption underlying PAT?underlying PAT?
• Markets are efficient (based on Efficient Markets Markets are efficient (based on Efficient Markets Hypothesis Hypothesis[EMHEMH])
• Markets Markets are are assumed assumed to be semito be semi-strong strong form form efficient. i.e. it is efficient. i.e. it isassume that capital markets react in an assume that capital markets react in an efficient efficient and and unbiased unbiasedmannermannerto to publicly available publicly available informationinformation.
• HenceHence, the market the market price of a firm’s securities reflects price of a firm’s securities reflects allallpublicly publiclyavailable information.available information.
• Individuals’ actions are driven by self interest. Hence, individuals Individuals’ actions are driven by self interest. Hence, individualswill always act in an opportunistic manner to the extent that the will always act in an opportunistic manner to the extent that theaction will increase their wealth.action will increase their wealth.
Does accounting choice matter?
Does accounting choice matter?
• According to EMH capital markets could “undo” the According to EMH capital markets could “undo” theimplications of management selecting different accounting implications of management selecting different accountingmethods.methods.
• Market “sees through” accounting method choices and to Market “sees through” accounting method choices and tothe extent that there were no apparent cash flow the extent that there were no apparent cash flowimplication (e.g., through changing taxes), there would be no implication (e.g., through changing taxes), there would be noshare price reaction.share price reaction.
• Hence, it doesn’t matter what inventory cost flow Hence, it doesn’t matter what inventory cost flowassumption or what measurement model for classes of assumption or what measurement model for classes ofproperty, plant and equipment is use.property, plant and equipment is use.
• If the choice of accounting method does not If the choice of accounting method does not matter to the matter to themarket, market, then:then:
– why do corporate managers lobby regulators to introduce particular why do corporate managers lobby regulators to introduce particularaccounting methods?accounting methods?
– Why companies switch accounting methods Why companies switch accounting methods
Why is agency
Why is agency theory important theory important to understand PAT?to understand PAT?
• Agency theory explains why selection of particular accounting Agency theory explains why selection of particular accountingmethods might matter methods might matter – hence crucial to the development of PAThence crucial to the development of PAT
• The ‘agency relationship’ is a central focus of agency theory. Agency The ‘agency relationship’ is a central focus of agency theory. Agencyrelationship is the relationships between principals and agents.relationship is the relationships between principals and agents.
– e.g. between shareholders (principals) and managers (agents) and between e.g. between shareholders (principals) and managers (agents) and betweendebt holders (principals) and managers (agents)debt holders (principals) and managers (agents)
– “a contract under which one or more (principals) engage another person (the “a contract under which one or more (principals) engage another person (theagent) to perform some service on their behalf which involves delegating some agent) to perform some service on their behalf which involves delegating somedecisiondecision-making authority to the agent” (making authority to the agent” (Jensen and Jensen and MecklingMeckling, 1976), 1976)
• Principals and agents are all assumed to act in their own selfPrincipals and agents are all assumed to act in their own self-interest interestin quests towards maximising their own welfare. in quests towards maximising their own welfare.
• The problem of getting The problem of getting agents to act in a manner consistent with agents to act in a manner consistent withmaximising principal’s maximising principal’s welfare is called welfare is called the the agency problem.agency problem.
– The agency problem relates to issues associated with motivating one party The agency problem relates to issues associated with motivating one party(the agent) to work in the best interests of another party (the principal)(the agent) to work in the best interests of another party (the principal)
• The agency problem leads to The agency problem leads to ‘agency costs’‘agency costs’
Agency
Agency relationshiprelationship
Agency
Agency problemproblem
Agency
Agency costscosts
What are agency costs?
What are agency costs?
Agency costs are costs incurred by principals (e.g., owners) because
Agency costs are costs incurred by principals (e.g., owners) because of asymmetric information, or conflicts of interest between principals of asymmetric information, or conflicts of interest between principals (e.g., owners) and agents (e.g., managers).(e.g., owners) and agents (e.g., managers).

Bonding costs
1.Bonding costs
Costs
Costs involved in agents bonding their behaviour to expectations of principals. involved in agents bonding their behaviour to expectations of principals.
E.g
E.g., the agent gives guarantee to undertake, or not to undertake, certain activities ., the agent gives guarantee to undertake, or not to undertake, certain activitiessuch such as preparing financial statementsas preparing financial statements
Monitoring costs
2.Monitoring costs
Costs
Costs of monitoring agents’ behaviour such as auditing financial statements of monitoring agents’ behaviour such as auditing financial statements
Residual costs
3.Residual costs
Residual
Residual costs are those costs associated with appointing agents that cannot be costs are those costs associated with appointing agents that cannot be avoided avoided despite the potential use of bonding and monitoring mechanisms. despite the potential use of bonding and monitoring mechanisms.
Not
Not all opportunistic actions of agents can be controlled by contractual all opportunistic actions of agents can be controlled by contractual arrangementsarrangements. Too costly to remove all opportunistic behaviour.. Too costly to remove all opportunistic behaviour.
What are the key hypotheses
What are the key hypotheses of PAT?of PAT?
• Three key hypotheses Three key hypotheses exists within PAT about when mangers would exists within PAT about when mangers wouldsupport or oppose a particular accounting methodsupport or oppose a particular accounting method
Management Compensation Hypothesis (or Bonus Plan Hypothesis)Management Compensation Hypothesis (or Bonus Plan Hypothesis)
Debt Hypothesis (or Debt/Equity Hypothesis)Debt Hypothesis (or Debt/Equity Hypothesis)
Political Cost Hypothesis Political Cost Hypothesis
Bonus plan hypothesis
Bonus plan hypothesis
• To align the interests of managers and owners, To align the interests of managers and owners,managerial bonus plans are likely to be managerial bonus plans are likely to beintroduced. According to these plans some part introduced. According to these plans some partof managers compensation depends on firm of managers compensation depends on firmperformance.performance.
• Managers Managers of firms with bonus plans are more of firms with bonus plans are morelikely to use accounting methods that increase likely to use accounting methods that increasecurrent period reported income current period reported income
– Such action increases the present value of Such action increases the present value ofbonuses paid to management if the bonuses paid to management if thecompensation committee of the board of compensation committee of the board ofdirectors does not adjust for the method chosendirectors does not adjust for the method chosen
– If managers are rewarded in terms of a measure If managers are rewarded in terms of a measureof performance (e.g., accounting profit), then of performance (e.g., accounting profit), thenthose managers will prefer accounting methods those managers will prefer accounting methodsthat have a greater impact on increasing profits.that have a greater impact on increasing profits.
When should bonuses be based on
When should bonuses be based on accounting measures?accounting measures?
• share returns relatively more sensitive to general market share returns relatively more sensitive to general marketmovementsmovements
• earnings have a high association with firmearnings have a high association with firm-specific movement in specific movement inthe firm’s share valuesthe firm’s share values
• earnings have a less positive association with marketearnings have a less positive association with market-wide widemovements in equity valuesmovements in equity values
Debt hypothesis
Debt hypothesis
• Managers will enter into debt covenants to align their interest with that of creditors. Managers will enter into debt covenants to align their interest with that of creditors.
• Debt covenants protect interest of debt holders (and also enable the firm to attract debt at a Debt covenants protect interest of debt holders (and also enable the firm to attract debt at alower cost due to reduced risk) lower cost due to reduced risk)
• In the absence of safeguards to protect their interests debtholders will require the firm to pay In the absence of safeguards to protect their interests debtholders will require the firm to payhigher higher interest interest to compensate for the risk (i.e. they will price protect)to compensate for the risk (i.e. they will price protect)
• Its therefore efficient for the firm and managers to enter into contracts that restricts the ability of Its therefore efficient for the firm and managers to enter into contracts that restricts the ability ofmanagers to adversely affect the wealth of managers to adversely affect the wealth of debtholdersdebtholders
• covenant covenant violation results in costs of technical violation results in costs of technical defaultdefault
• A debt covenant is an undertakings provided by a borrower as part of a contract associated with a debt covenant is an undertakings provided by a borrower as part of a contract associated with aloan, which restrict the borrower from taking particular action that dilute the claim of debt holders or loan, which restrict the borrower from taking particular action that dilute the claim of debt holders orspecifically require the borrower to take particular actionspecifically require the borrower to take particular action
• Debt covenants may restrict firms from: Debt covenants may restrict firms from:
• paying paying excessive dividends to shareholders; excessive dividends to shareholders;
• taking additional debt with new debtholders competing with original debtholders for repayment taking additional debt with new debtholders competing with original debtholders for repaymentresulting in claim dilutionresulting in claim dilution
• Investing in highInvesting in high-risk projects which risk projects which are are not not beneficial beneficial to to debtholders debtholders as they have a fixed claim as they have a fixed claim(asset substitution)(asset substitution)
• Underinvesting in projects so as to attract debt at lower Underinvesting in projects so as to attract debt at lower costcost
• Debt covenants may include maintaining Debt covenants may include maintaining a particular debt/equity ratio and/or interest coverage ratioa particular debt/equity ratio and/or interest coverage ratio
• The The higher the firm’s debt/equity higher the firm’s debt/equity ratio:ratio:
• the closer the firm is to the constraints in debt covenants and the closer the firm is to the constraints in debt covenants and
• the more likely managers use accounting methods that increase income which will relax debt the more likely managers use accounting methods that increase income which will relax debtconstraints and reduce the cost of technical defaultconstraints and reduce the cost of technical default
Political cost hypothesis
Political cost hypothesis
• Political costs are costs resulting from political attention from Political costs are costs resulting from political attention fromgovernment, lobby groups etc.government, lobby groups etc.
• High reported profits can be used as a means to criticise High reported profits can be used as a means to criticisecompanies for charging consumers too much for their companies for charging consumers too much for theirproducts products (resulting in possible resulting in possible product boycotts), call for product boycotts), call forgovernment action against a company, call for increasing taxes government action against a company, call for increasing taxeson companies, call for higher salaries for employeeson companies, call for higher salaries for employees
• Firms Firms subject to political scrutiny will adopt accounting subject to political scrutiny will adopt accountingmethods that reduce reported income to lower political methods that reduce reported income to lower politicalscrutinyscrutiny
• Large Large firms firms are subjected to more political scrutiny than are subjected to more political scrutiny than small smallfirms. Hence, large firms firms. Hence, large firms are more likely to use accounting are more likely to use accountingchoices that reduce reported profitschoices that reduce reported profits
• Reduction of reported income is hypothesised to reduce the Reduction of reported income is hypothesised to reduce thepossibility that people will argue that the organisation is possibility that people will argue that the organisation isexploiting other parties by applying business practices that exploiting other parties by applying business practices thatgenerate excessive profits for the benefit of owners while at generate excessive profits for the benefit of owners while atthe same time providing limited returns to other stakeholders the same time providing limited returns to other stakeholders(e.g., employees).(e.g., employees).
• Politicians know that highly profitable Politicians know that highly profitablecompanies could be unpopular with companies could be unpopular withmembers of their constituencymembers of their constituency
• Politicians (who are assumed to be Politicians (who are assumed to bedriven by selfdriven by self-interest like everybody interest like everybodyelse) could win votes by taking actions else) could win votes by taking actionsagainst the against the companiescompanies
Two perspectives adopted by PAT
Two perspectives adopted by PAT researchresearch
• Efficiency perspective (Efficiency perspective (ex anteex anteperspective perspective – before the fact)before the fact)
– Considers what mechanisms are put in place upfrontConsiders what mechanisms are put in place upfront
– Managers select accounting methods which most efficiently reflect underlying Managers select accounting methods which most efficiently reflect underlyingfirm performancefirm performance
– regulation forcing firms to use a particular accounting method imposes regulation forcing firms to use a particular accounting method imposesunwarranted costs and introduces inefficienciesunwarranted costs and introduces inefficiencies
• Opportunistic perspective (Opportunistic perspective (ex post ex post perspective perspective – after the fact)after the fact)
– Takes the negotiated contractual arrangement as given, and considers the Takes the negotiated contractual arrangement as given, and considers theopportunistic action that could be undertaken once various contractual opportunistic action that could be undertaken once various contractualarrangements are put in placearrangements are put in place
– particular accounting methods might initially be selected for efficiency reasons, particular accounting methods might initially be selected for efficiency reasons,but once they have been negotiated/agreed, then managers will aim to utilise but once they have been negotiated/agreed, then managers will aim to utiliseaccounting choices in a way that best serves their own interestaccounting choices in a way that best serves their own interest
– Not possible to write complete contracts, so managers are assumed to Not possible to write complete contracts, so managers are assumed toopportunistically act to maximise own wealthopportunistically act to maximise own wealth
Why conservative accounting methods
Why conservative accounting methods are better for efficient contracting?are better for efficient contracting?
• Conservative accounting methods lead to:Conservative accounting methods lead to:
• relatively lower revenue recognitionrelatively lower revenue recognition
• faster expense recognitionfaster expense recognition
• higher liability recognitionhigher liability recognition
• lower asset recognitionlower asset recognition
• Historical cost accounting is a conservative approach to accounting when Historical cost accounting is a conservative approach to accounting whencompared to fair value accountingcompared to fair value accounting
• Conservative accounting methods, such as historical costs, reduce the Conservative accounting methods, such as historical costs, reduce theability of managers to manipulate accounting numbers ability of managers to manipulate accounting numbers (or (or undertaking undertakingopportunistic earnings opportunistic earnings management) compared management) compared to fair value accountingto fair value accounting
• Hence, organisations Hence, organisations that use conservative accounting methods might be able to that use conservative accounting methods might be able toattract debt and equity capital at a lower cost because of attract debt and equity capital at a lower cost because of perception of perception of lower risklower risk
• conservative accounting methods provide benefits in terms of controlling conservative accounting methods provide benefits in terms of controllingpotentially divergent behaviour of individuals involved in various contractual potentially divergent behaviour of individuals involved in various contractualarrangements.arrangements.
Criticisms of PAT
Criticisms of PAT
• Does not provide prescriptionDoes not provide prescription
• PAT is not valuePAT is not value-free as it asserts assumption that all action is driven by selffree as it asserts assumption that all action is driven by self-interest interest
• Argued to be too negative and simplistic a perspective of humankindArgued to be too negative and simplistic a perspective of humankind
• Issues have not shown great developmentIssues have not shown great development
• In undertaking largeIn undertaking large-scale empirical research, researchers ignore scale empirical research, researchers ignoreorganisationalorganisational-specific relationshipsspecific relationships