Chapter 07

Financial Accounting Theory
Craig Deegan
Chapter 7
Positive Accounting Theory
Slides written by Michaela Rankin
Copyright © 2000 McGraw-Hill Book Co. Aust. PPT t/a Financial Accounting Theory by Deegan 7.1
Chapter 7: Positive Accounting Theory
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
– 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
Learning Objectives
– 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
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
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
PAT defined—continued
• 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
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
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
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
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
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
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 upon traditional economics literature
– assumptions of self-interest and wealth
maximisation
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
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
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
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
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
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
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
Two perspectives adopted

by PAT research
• Efficiency perspective
• Opportunistic perspective
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
Efficiency Perspective—
continued
• PAT theorists argue that regulation forcing
firms to use a particular accounting method
imposes unwarranted costs
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
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
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
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 in part tied to firm
performance
– known as bonus schemes
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
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
Incentives to manipulate
accounting numbers
• Rewarding managers on the basis of
accounting profits may induce them to
manipulate accounting numbers
– 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
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’)
numbers—evidence continued
• 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
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
Market-based bonus
schemes—continued
• 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
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
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
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
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
Australian debt contracts—

continued
– Debt to assets, interest coverage and current
ratio clauses frequently in use
– interest coverage required to be between 11/2
and 4 times
– current ratio clauses required current assets be
between 1 and 2 times the size of current
liabilities
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
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
– when the firm has borrowed funds, and
accounting-based covenants are in place to
protect the investment of debtholders
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
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
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
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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Chapter 07

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Financial Accounting Theory

Positive Accounting Theory

Assumptions underlying PAT

Role of accounting in contracts

Bonus plan hypothesis

Political cost hypothesis

Two perspectives adopted

Owner / manager contracting

Accounting-based bonus plans

Market-based bonus schemes

Choice of accounting versus

Use of debt contracts

Australian debt contracts

Australian debt contracts—

Role of external auditors

Political actions of individuals

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