Positive accounting theory (pat) Bonus Plan Hypothesis , Debt Covenant Hypothesis ,Political Cost Hypothesis
BONUS PLAN HYPOTHESIS DEBT COVENANT HYPOTHESIS POLITICAL COST HYPOTHESIS Group Members :-1) Maznah Binti Zakaria (P63559)2) Nur Asiah Binti Abd.Rashid (P63558)3) Maryam Youssefinejad (P64537)
INTRODUCTION1) Positive Accounting Theory (PAT) concerned with predicting such actions as the choices of accounting policies by firms & how firms will respond to proposed new accounting standard.2) PAT uses theory to predict the choices that management will make regarding their choice of accounting policies.3) This theory is introduced as a way to merge efficient securities markets with economic consequences.4) PAT takes the view that firms will conduct themselves in the way that maximizes their own best interests.5) Managers do not always do what is best for shareholders, but what will be the most beneficial to their organization.6) The choices that an organization makes are dependant on what industry they are in, and the factors within that industry.7) PAT emphasizes that an organization’s choice of accounting policies is motivated by keeping contract costs down.
INTRODUCTION (continue) Efficiency Perspective Bonus Plan Positive HypothesisAccounting Theory Debt Covenant Opportunistic Hypothesis Perspective Political Cost Hypothesis
INTRODUCTION1) Assumes that managers with bonus plan (tied to reported) as more likely to use accounting methods that increase current period reported income.2) It predicts that if a manager is rewarded in terms of a measure of performance such as accounting profits, the manager will attempts to increase profits.
INTRODUCTION (continue)3) Managers use discretionary accruals to maximize their short-term bonus (Healy 1985)-known as Bonus Maximization Hypothesis. - use discretionary accruals to manipulate earning (discretionary accounting is non-obligatory expenses-such as bonus & bad debt provision that is yet to be realized but recorded in the account book. A company may or may not be be recognize this expenses). -Healy’s Finding : Managers observe income before discretionary accruals and make either income-increasing or decreasing discretionary accruals based on company bonus plan: i) Income-decreasing when income before discretionary accruals is below the lower bound or above the upper bound-they anticipate increasing the probability of earning a bonus in future. ii) Income-increasing when income before discretionary accruals falls between the upper and lower bound- they can get higher bonus in the current period.
Executive Compensation, Investment Opportunities, and Earnings Management:High-tech Firms versus Low-tech Firms Author : 1) Sun S.Kwon (School of Administrative Studies ,Atkinson College, York University) 2) Qin Jennifer Yin (Department of Accounting, College of Business, University of Texas at San Antonio) Published in : Journal of Accounting, Auditing and Finance, 21(2), 2006, pp. 119-148.
EXECUTIVE COMPENSATION, INVESTMENT OPPORTUNITIES, AND EARNINGS MANAGEMENT: HIGH-TECH FIRMS VERSUS LOW-TECH FIRMS INTRODUCTION1) Questions exist on whether high-tech firms and low-tech firms use performance measures, including stock and accounting performance, in the same way when determining compensation contracts.2) Prior research indicates that the market valuation for high-tech stocks differs from that for traditional stocks.3) Hand (2000) asserts that the conventional assumption that accounting information maps into the equity market value in a linear and stationary manner is not relevant to technology-intensive firms.4) Although the relevance of performance measures for valuing a firm may differ for executive contracting purposes, the link between executive pay and reported earnings is sensitive to the underlying value in earnings (Bushman et al. ).
EXECUTIVE COMPENSATION, INVESTMENT OPPORTUNITIES, AND EARNINGS MANAGEMENT: HIGH-TECH FIRMS VERSUS LOW-TECH FIRMS INTRODUCTION (continue)5) The nature of the high-tech business may provide one possible reason for these differences. High-tech firms must invest more in such intangible assets as R&D, human resources, customer acquisition, brand development, and other information technology in comparison to low-tech firms.6) To survive in the fast-changing, fiercely competitive high-tech market, these firms also incur greater and more frequent unusual or nonrecurring expenses, including :7) inventory write-downs, restructuring/ reorganization expenses, and write- downs or write-offs of receivables and intangibles that potentially lower their earnings reports.8) Further, investment projects typically are more difficult to observe and monitor than assets-in-place (Smith & Watts ; Krishnan & Kumar ), and9) This increases the information asymmetry between the principal (shareholders) and the agent (managers) in high-tech firms, creating a need to monitor managers’ performance through compensation contracts (Jensen & Meckling ; Fama & Jensen ).
EXECUTIVE COMPENSATION, INVESTMENT OPPORTUNITIES, AND EARNINGS MANAGEMENT: HIGH-TECH FIRMS VERSUS LOW-TECH FIRMSCOMMAND HIGHER LEVELS OF TO REDUCE AGENCY COSTS ARISINGCOMPENSATION FOR THE FROM INFORMATIONALINFORMATIONAL ADVANTAGES ASYMMETRY• CEOs provide on investment projects and • to tie CEO compensation closely to increased risk exposure related to investment managerial efforts of accomplishing opportunities investment goals in the best interest of their shareholders WHY HIGH-TECH FIRMS USE THE COMPENSATION INSENTIVES (DISCRETIONARY ACCRUAL)HIGH-TECH FIRMS INCUR LARGE EXPENSES TO GENERATE AND EXPLOITINVESTMENT OPPORTUNITIES THAT POTENTIALLY LOWER ACCOUNTINGEARNINGS.• If high-tech firms base large portions of managers’ compensation on accounting earnings, it may encourage such undesired management behavior as becoming myopic and forgoing projects that reduce current earnings but have positive net present value.• Using long-term incentives alleviates the horizon problem and avoids penalizing managers for activities that improve the long-term prospects of the company but reduce current income.• Thus, high-tech firms’ compensation contracts are likely to emphasize the relative use of stock-based performance measures and tie compensation to stock returns.
EXECUTIVE COMPENSATION, INVESTMENT OPPORTUNITIES, AND EARNINGS MANAGEMENT: HIGH-TECH FIRMS VERSUS LOW-TECH FIRMSTO ACHIEVE THE EARNINGS TO INFLUENCE INVESTORBENCHMARK PERCEPTION OF THE FIRM VALUE • when discretionary accruals convey relevant• since significant economic benefits information about performance and potentially accrue to firms when earnings • when CEOs use discretionary accruals to prevent meet or beat analysts’ forecasts. large declines in stock prices by meeting or beating analysts’ forecasts.WHY HIGH-TECH FIRMS USE THE COMPENSATION INSENTIVES (USE DISCRETIONARY ACCRUAL) TO MEET OR BEAT ANALYSTS’ HIGHER LEVELS OF VOLATILITY IN TECH EXPECTATIONS AS AN IMPORTANT STOCK PRICES ASPECT OF PERFORMANCE. • mean that shareholders of high-tech firms are more • The accrual process allows CEOs to exercise likely to experience a large decline in wealth at some judgment in communicating private information time. about the future prospects for their firms (Healy • In response to these pressures, compensation & Palepu ; committees are likely to reward executives who use • Dechow ). Guay, Kothari, and Watts (1996) discretionary accruals to match analysts’ forecasts. assert that managers use discretionary accruals to incorporate the impact of current economic events into current reported earnings. • The information environment is complex in high- tech firms, and investors must infer true earnings from reported accounting earnings because they cannot easily observe true economic earnings.
EXECUTIVE COMPENSATION, INVESTMENT OPPORTUNITIES, AND EARNINGS MANAGEMENT: HIGH-TECH FIRMS VERSUS LOW-TECH FIRMS RESEARCH OBJECTIVE1) Examine the systematic differences between high-tech & low-tech firms in compensation policies.2) Examine the sensitivity of compensation to market & accounting performance.3) Examine earning management in the presence of investment opportunities.
EXECUTIVE COMPENSATION, INVESTMENT OPPORTUNITIES, AND EARNINGS MANAGEMENT: HIGH-TECH FIRMS VERSUS LOW-TECH FIRMS • High-tech • High-tech firms firms pay pay less in cash • The association • The association higher levels salaries and between changes in between of executive bonuses but compensation and compensation and compensation offer more stock changes in stock discretionary accruals than low-tech options than firms. low-tech firms. performance is higher, is higher in high-tech and the association firms than in low- between changes in tech firms, especially compensation and when earnings before changes in accounting discretionary accruals performance is lower, are lower than for high-tech firms analysts’ earnings than for low-tech forecasts. firms.HYPOTHESIS HYPOTHESIS HYPOTHESIS HYPOTHESIS
EXECUTIVE COMPENSATION, INVESTMENT OPPORTUNITIES, AND EARNINGS MANAGEMENT: HIGH-TECH FIRMS VERSUS LOW-TECH FIRMSSENSITIVITY TEST (CONFOUNDING FACTORS REGULATION SIZE EFFECT DEBT EFFECT EFFECT• compensation relates to • executive compensation • Debt to-asset ratios differ firm size: varies inversely with levels significantly between high- • large firms typically have of regulation because tech and low-tech firms, so more complex structures regulations restrict the it is particularly important and require a greater chief executive officer’s to control for the effect of level of managerial investment discretion and debt. effort than small firms. reduce the marginal • Even though firm size product of the decision does not differ maker. significantly between high-tech and low-tech firms it may have affected previous regression results because firm size was not explicitly controlled for in the regression models.
EXECUTIVE COMPENSATION, INVESTMENT OPPORTUNITIES, AND EARNINGS MANAGEMENT: HIGH-TECH FIRMS VERSUS LOW-TECH FIRMS CONCLUSION1) high-tech firms generally pay a higher level of total compensation than low-tech firms.2) high-tech firms use lower cash salaries and bonuses but larger amounts of stock options grants when rewarding CEOs3) the association between compensation and stock returns is higher for high-tech firms, and find no difference in the association between compensation and accounting returns in both groups4) the positive association between bonus and discretionary accruals is higher for high- tech firms than for low-tech firms, especially when earnings before discretionary accruals are lower than the mean earnings forecast.5) The results are robust to various sensitivity analyses, including controlling for potentially confounding effects related to size, debt, and regulation; using alternative specifications of accounting and market performance measures; and a variety of procedures to attenuate the effects of extreme values.6) The overall results indicate systematic differences between high-tech and low-tech firms in compensation policies, choices of performance indicators, and the treatment of earnings management. The interpretation is that differences in information environment between high-tech and low-tech firms lead to different structures for compensation contracts.
EXECUTIVE COMPENSATION, INVESTMENT OPPORTUNITIES, AND EARNINGS MANAGEMENT: HIGH-TECH FIRMS VERSUS LOW-TECH FIRMS Provide evidence that industry membership, that is, high- tech versus low-tech, has incremental contracting value in determining executive compensation beyond the IOS CONTRIBUTION Demonstrate that compensation committees Suggest that the increasing number of use compensation contracts to encourage high-tech firms and those firms’ need CEOs to use discretionary accruals to to change compensation strategies to improve the ability of earnings to reflect the use more stock-based compensation as economic value of high-tech firms, especially business environments become more when information asymmetry is high. The uncertain results of this study support the agency cost explanation of corporate policy choices.
DEBT COVENANT HYPOTHESISDebt covenant• Restrictions placed on a borrower/ bond issuer by the lender/ bank that granted the loan/ credit via loan agreement (normally) or in a separate agreement.• Debt Covenant - An agreement between lender and borrower that enable lender to place a limit on: • Payment of dividend • Production and investment • Issuance of new debt • Payoff pattern • Accounting ratios
DEBT COVENANT HYPOTHESIS(continue)• Attempts to limit managers ability to transfer assets to themselves, new shareholders, or new creditors.• Violation of covenant - immediate payment of principal and interest• Renegotiating the terms of the debt: Accelerated the principal payment Increase interest rate Liens on assets Other restriction on accounting ratio and activities• Overall higher cost to the company
DEBT COVENANT HYPOTHESIS (continue)• 2 types :- - positive/ affirmative covenant : require certain actions. E.g require a borrower to maintain certain level of financial ratios or capital - negative covenant : limits certain actions. E.g. a borrower is prevented from taking more debt backed by its assets
Debt Covenants and Accounting Conservatism By Valery V. NikolaevAuthor : Valeri V.Nikolaev (The University of Chicago Booth School of Business)Published in : Journal of Accounting Research Vol. 48 No. 1 March 2010 Purpose of study - test whether firm that rely on covenants in their public debt contracts recognize economic losses in earnings in a more timely fashion.
ROLE OF DEBT COVENANT• Debt covenant limit a manager’s ability to opportunistically expropriate wealth from bondholder when a firm approach economic distress.• But this only become binding if the accounting system recognize the deterioration of company’s financial position.• Timely loss recognition is expected to improve the efficiency • more likely to binding in distress • Thus, limit opportunistic action by manager.
ROLE OF TIMELY LOSS RECOGNITION AND THE USE OF COVENANTSTimely loss recognition enhance efficiency of debt contracting in :By facilitate early transfer of decision right to bondholders Facilitate the signaling role of covenants.
Accounting serve Therefore , lead tocontracting are need increase demands for timely recognition of (Watts and economic losses inZimmerman, 1986), accounting earning.
ECONOMIC DIFFERENCES EXIST BETWEEN :- Private Debt Public Debt (bank loan) (bonds)• Consider superior monitor – • Seldom require maintenance of direct access to internal accounting ratio – due to higher renegotiation cost associate with information diffuse ownership.• Maintain certain financial ratio – • Require annual compliance tighter range certification • result to covenants violations and subsequent renegotiation • Thus be more concern than • Private debtholder control. private lender with the degree of Thus, reduce scope of timely recognition of losses. managerial opportunism• Usually require quarterly compliance covenants
HYPOTHESES Timely recognition of economic losses increase with the use of debt covenants in public debt contract Companies that rely on debt covenants more extensively exhibit a greater increase in timely recognition of economic losses following debt issue.
EXTENSION TO THE PREVIOUS STUDY o Under same GAAPArgue that debt market jurisdiction and capitalinfluence the degree of structure - the design ofaccounting conservatism. debt contract has anHowever the evidence is incremental effect onlargely limited to cross- reporting incentivescountry and cross marketexplanations. o Document the link timely(Watts and Zimmerman, 1986; Ball, loss recognition and publicKothari, and Robin, 2000; Watts, debt covenants.2003a,2003b; Ball andShivakumar,2005; Ball and Sadka,2008)
FINDING• Public debt contract employ more covenants exhibit timelier recognition of economic losses• Exhibit higher level of timely loss recognition both before and after the issue• Extensively experience an increase in timely loss recognition after the issue. Thus, use of covenants in public debt contracts is associated with increased demand for timely loss recognition.
FIRM-STAKEHOLDER INTERACTION-PERSPECTIVES Firm-stakeholder interaction-perspectives Positive /normative Positive perspectives Normative perspectives perspectives Aida in interpretation Theories of theoryShareholder Agency theory Stakeholder agency theory power Instrumental stakeholder theory Positive accounting theory : the political cost hypothesis
THEORETICAL PERSPECTIVES OF THE FIRM- STAKEHOLDER RELATIONSHIPStakeholder Underlying Notion CharacteristicsPerspectiveThe Political Cost Reaction of the firm to Regulatory WealthHypothesis (PCT) the possibility of Effects intervention by regulators, and other interest groups who might be able to affect firm wealth. The firm takes action to provide information with the intention of offsetting.
Macroeconomic control , political costs and earnings management : evidence from Chines listed real estate companies Author : Donghua Chen, Jieying Li, Shangkun Liang ⇑, Guojun Wang (Institute of Accounting and Finance, Department of Accounting, School of Business, Nanjing University, China) Published in : China Journal of Accounting Research 4 (2011) 91–106
Firms in China have involved high political costs during China’seconomic, because they are affected by macroeconomic policies . This study answer that whether real state firms attempt to decrease earning during periods of macroeconomic control , using variable related to the national realestate market as samples for political costs.
The political cost hypothesis is one of the three basichypothesis of positive accounting theory has long been an important issue in positive accounting research .This research on transition and emerging economies is limited , compare with prior research that has mainly focused on mature Western market economies . There are big political and economic differences in the backgrounds of mature and emerging markets . Mature markets Emerging compare (Western countries) market(China)
Accordingly , the purpose of this study is to find whether the political costs hypothesis of earnings management differs between emerging and mature markets . Or Is the political costs hypothesis applicable to China ? Do listed companies in China face different costs compared to listed companies in Western countries ? Which variables best characterize the political costs of listed companies in China ? Do China’s listed companies consider political costs when they manipulate earnings ?
The development and stability of real estate market can greatly affect macroeconomic operations and social stability . Overall , the government’s aim is to use various policy tools tocontrol real estate prices to achieve a more reasonable price level . To . avoidBeing subject to more stringent regulations and public scrutiny , real estate companies are likely to adopt earnings decreasingaccounting policies . Thus , the rapid development of China’s real estate market and subsequent regulatory changes provide an excellent research and experimental setting in which to examine the relationship between political costs and corporate earnings management behavior in an emerging market .
Doing an empirical study to determine whether the political costshypothesis is applicable to China , the results show that , with theimplementation of increasingly miserly macroeconomic controls , listed real estate companies adopted earnings decreasing accounting policies . In addition , because state –owned real estate companies have a different sensitivity to political costs ,non-state –owned listed companies have more incentive to adopt earnings decreasing accounting policies .Also , this study shows that macroeconomic controls can providean incentive for earnings management , which is different from theeffects of political costs found in Western countries . And , due to the asymmetric effects of the same macroeconomic policies , different political cost sensitivities are found to exist betweendifferent types of companies . These finding compost the political costs hypothesis and our understanding of the impact of macroeconomic policies in the institutional setting of China .
ALTERNATIVE MEASURE OF POLITICAL COSTS Company SizeEarly research like watts and zimmerman found that , comparedwith small companies , large companies are more likely to accept General Price Level Adjusted (GPLA) accounting standards , because profits adjusted by the guidelines are lower thanunadjusted profits . They analyze the reasons for this phenomenaand found that larg companies have a greater motivation to hide profits , because once profits are considered to be derived from monopoly situations , the government may institute wealth transfer policies.
STAKEHOLDERS LEGITIMATE RIGHTS STAKEHOLDERS INTRINSIC VALUE Corporate Tax Rates Are also an important alternative measure of political costs . Corporations that are free from political involvement generally have lower tax rates . Alternatively , companies with higherprofits are more easily identified by governments and tend to have higher tax rates . Therefore ,enterprises have motives to reduce the amount of tax payable .
EXAMPLE FOR CORPORATE TAX RATESHan and Wang showed that during the 1990 Persian Golf crisis , many US oil processing enterprises adopted measured to reduce current profits , such as changing accounting policies and reducing their closing inventory , to avoid being liable forthe windfall profit tax as a result of the sharp rise in oil prices . They studied the accounting policies used by oil companies during the 1990 Gulf Crisis when oil prices were rising , they found that oil companies decreased their earnings in 1990 though inventory and special accruals in the third and forthquarters to reduce the high political costs associated with this large abnormal growth in income .
To resolve this problem , weshould understand the political and economic differences between China and the West .
FIRST : RELATES TO THE SYSTEM OF GOVERNANCEWestern Countries ChinaPolitical power belongs to the Power is distributed amongelected parliament many government departments As emerging countries invariable have weak legal systems , political power is much more easily co-opted by large corporation Settlement costs are much lower for large corporations
SECOND : POLITICAL REASONS FOR MANAGING THE ECONOMYWestern Countries ChinaThe main purposes are to avoid This aims are realized bymonopolies , protect the regulating certainenvironment or increase tax characteristics of largerevenues corporations The goal of emerging countries is not to limit the scale of companies , but to encourage them to become stronger and more competitive Economic stability is also very important for this emerging and transforming nation
THIRD : the objective of the government’s economicmanagement .There are few state-owned companies in the West ,but there are many large state-owned companies inChina .and non-state-owned companies are affectedby government economic management more thanstate owned companies .THE LAST DIFFERENCE : the forms of economicmanagement .It is significant that the Chines economy stated from aplanned economy . Thus , the government is used toimplementing industrial policies . When a company’sdevelopment matches the governments industrialpolicies , it will be encouraged.
In summary , China is an emerging country in theprocess of economic transition . The political costsof companies in China are quite different from thosefaced by companies in Western countries .These differences are reflected in many aspects ofthe system of government ,• The motivation for governing• The form of government• The different circumstances that are subject to economic control
RELATIONSHIP BETWEEN EARNING MANAGEMENT BEHAVIOUR AND POLITICAL COST IN AN EMERGING MARKET Real estate in China is the most important and largest industry . Also is an important investment target for families companies . With the increase in the scale of the realestate market , its development and change now affect not only financial security and social stability , but also the health of the entire national economy .
The importance of the real estate industry isbeyond question and it is also undoubtedlywithin the scope of intervention .When house prices rise too fast and causebroad public concern or even threatenmacroeconomic stability , the government cantake necessary measures to manage the realestate industry .
Between 1994 Between 1998 and and 1997 2002 The real estate market China carried out a series of stagnated policies to support and encourage the growth of the real estate industry After 2001 the real estate industry in China gradually In 2005 the prices forentered a trend of rapid growth condominiums increasedIn 2003 real estate investment in In early 2006 house price china increased by 30.33% soared in cities compared to the previous yearIn the same year house price Accordingly , the sharprose much faster than in past rise in house prices years
These macroeconomic controls had a long-term impact and deeply affected the real estate industry. The policies were basedon the high prices of housing and the huge profits being earned by real estate companies. Therefore, the data on real estate companies’ net profits play an important and sensitive role in our analysis. Because the restrictive policy was instituted by the government,real estate companies have an incentive to decrease their reported company profits to avoid political costs.
CONCLUSION , LIMITATION AND FUTURE RESEARCH DIRECTIONSUsing a sample of listed real estate companies between 2002 and2007, we conduct an empirical study of the politicalcosts hypothesis for earnings management in the context of China.The results show that, to avoid the negative impact oftightening government policies, listed real estate companies havean incentive to decrease current earnings. The motivationto conduct earnings management is greater for non-state-ownedreal estate companies than state-owned companies. However,we do not find evidence that ordinary state-owned enterprises aremore sensitive to political costs compared to centralgovernment enterprises. The results of our study demonstrate thatclose attention needs to be paid to economic indicatorsthat act as references for macroeconomic controls whenconducting earnings management research in the context of China.
CONCLUSION , LIMITATION AND FUTURE RESEARCH DIRECTIONSOur first contribution to the earnings management literatureis that company size, commonly used as a proxy for politicalcosts in traditional Western research, does not apply in thecontext of China. Economic indicators that act as referencestomacroeconomic controls may be more accurate. Second, wetest for differences in political cost sensitivity in differenttypesof corporations, thereby enriching the approach to politicalcosts research in China. Our findings provide a reference forgovernmentindustrial policy during transition periods.
CONCLUSION , LIMITATION AND FUTURE RESEARCH DIRECTIONSThere are a number of limitations to this study. First, we created newvariables as proxies for political costs that havenever been used in previous studies. We do not study the importanceof real estate prices for government regulation orhow political costs are applied to the real estate industry. Furtherresearch is needed in this field, for example, to examinewhether the ease of re-financing and the level of tax incentives playimportant roles in earnings manipulation. Second, ourpolitical cost indicator is limited to the macroeconomic level and wefail to identify the political costs of individual companies.In addition, as there are a variety of real estate price indexes, it may bequestionable whether our indicator is the mostappropriate. These choices may all have an impact on the final results.Third, our sample is limited to the real estate industry,which weakens the generalizability of our conclusions. Nonetheless,