7-1 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Financial Accounting TheoryCraig Deegan

Chapter 7

Positive accounting theory

Slides written by Craig 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

– 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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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 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

• 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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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 (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 PAT—Agency 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 decision-making 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 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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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 basis—salary 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 firm’s 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 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

– 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 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 firm’s share values

– earnings have a less positive association with market-wide movements in equity values

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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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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

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Australian debt contracts (cont.)

– debt to assets, interest coverage and current ratio clauses frequently in use

– interest coverage required to be between 1½ 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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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

• 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