Financial Accounting Theory Craig Deegan Chapter 7

Financial Accounting Theory Craig Deegan
Chapter 7 Positive accounting theory Slides written by Craig Deegan and Michaela Rankin
Copyright 2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan
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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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Positive compared to normative theories

A positive 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
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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. (Watts and Zimmerman 1986, p. 7)
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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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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
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
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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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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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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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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 decisionmaking authority to the agent
Relies on traditional economics literature

assumptions of self-interest and wealth maximisation
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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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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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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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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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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 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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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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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 (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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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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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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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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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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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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Choice of accounting versus marketbased 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 marketwide movements in equity values
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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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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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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
7-34
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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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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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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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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Financial Accounting Theory Craig Deegan

Positive compared to normative theories

Positive Accounting Theory defined

Positive accounting theory defined (cont.)

Assumptions underlying PAT

dominant research paradigm in 1970s and 1980s

Origins of PATcapital markets research

Origins of PATcapital markets research (cont.)

Literature unable to explain why particular accounting methods selected

Origins of PATAgency theory

Information asymmetries create much uncertainty

Relies on traditional economics literature

Role of accounting in contracts

Research assumes managers will act opportunistically when selecting methods

Bonus plan hypothesis

Political cost hypothesis

Two perspectives adopted by PAT research

Costs of divergent behaviour are agency costs

Owner/manager contracting (cont.)

Methods of rewarding managers

Salary plus remuneration is, in part, tied to firm performance

Accounting-based bonus plans

Incentives to manipulate accounting numbers

Bonuses based on profits cause short-term rather than long-term focus

Incentives to manipulate accounting numbersevidence

Lewellen, Loderer and Martin (1987) found

Market-based bonus schemes

Market-based bonus schemes (cont.)

Choice of accounting versus marketbased bonus schemes

Debt contractingagency costs of debt

Use of debt contracts

Australian debt contracts

Australian debt contracts (cont.)

Debt contractsmanagers incentive to manipulate

Role of external auditors

Political actions of individuals

May rely on reported profits to justify actions

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