Deegan fat4e ppt_ch07

7-1
Copyright © 2014 McGraw-Hill Education (Australia) Pty Ltd
PPTs to accompany Deegan, Financial Accounting Theory 4e
FINANCIAL ACCOUNTING THEORY
Craig Deegan
Slides written by Craig Deegan
CHAPTER 7
Positive Accounting Theory

7-2
Learning objectives
7.1 Understand how a positive theory differs from a normative
theory.
7.2 Be aware of the origins of Positive Accounting Theory (PAT).
7.3 Understand that PAT uses insights from agency theory and
why agency theory is of relevance to financial accounting
practices.
7.4 Be aware of the central assumptions of PAT.
7.5 Be aware of the meaning and nature of agency costs.
7.6 Understand why an organisation can usefully be referred to
as a ‘nexus of contracts’.
7.7 Understand the perceived role of accounting in minimising the
transaction costs of an organisation.
continued

7-3
Learning objectives (cont.)
7.8 Be aware that accounting policy choices made by
management will be influenced by both efficiency
considerations as well as opportunistic motivations.
7.9 Be able to identify the reasons for the existence of ‘creative
accounting’.
7.10 Be able to explain the meaning of ‘political costs’ and how
accounting can be used to reduce the costs associated with
various political processes.
7.11 Understand the role of accounting-based management
compensation schemes and debt covenants in reducing
potential conflicts (agency costs) within an organisation.
7.12 Understand how particular accounting-based agreements
with parties such as debtholders and managers can provide
incentives for managers to manipulate accounting
numbers. continued

7-4
Learning objectives (cont.)
7.13 Be aware of what constitutes ‘conservative’ accounting
procedures and why conservative accounting procedures
provide efficient mechanisms for minimising the contracting
costs within an organisation.
7.14 Understand the relevance of PAT to current debates about
how assets and liabilities should be measured.
7.15 Be able to identify some of the criticisms of PAT.

7-5
Positive theories 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 explain the practice of accounting)
• By contrast, normative theories (which were
considered in Chapters 5 and 6) prescribe how a
particular practice should be undertaken
– the prescription might depart from existing practice

7-6
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)
• Again, positive theories do not prescribe what should
occur – they focus on explaining or predicting what
does occur
continued

7-7
Positive Accounting Theory defined
(cont.)
• PAT focuses on relationships between various
individuals and explains how accounting is used to
assist in the functioning of these relationships
• Examples of relationships
– between owners and managers
– between 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

7-9
Origins of PAT
• Started coming to prominence in mid-1960s
– paradigm shift from normative theories
• PAT became the 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

7-10
Origins of PAT—capital
markets research
• Development of Efficient Markets Hypothesis (EMH)
by Fama and others provided an environment
suitable for PAT research
– 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
– sought to explain market reactions continued

7-11
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
• But the literature was unable to explain why particular
accounting methods were selected – if the market was efficient
as commonly assumed by researchers, and could understand
how different accounting methods affect accounting numbers,
then why does it matter what accounting method was selected?
PAT addresses this issue

7-12
Firms and contracts
• Firms can be characterised as a nexus of contracts
– between consumers of products and the suppliers of factors
of production
• Firms exist because they reduce contracting costs,
– firms provide an efficient means of organising economic
activity
– [consider the alternative, an individual organising the
production of a good: acquiring the raw materials organising
various people to make the good]
• Contracts include all types of agreements between
two or more parties (not necessarily written
contracts)

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Origins of PAT—agency theory
• Agency theory was crucial to the development of
PAT
• Agency theory explained why the selection of
particular accounting methods might matter
• Focused on the relationships between principals and
agents
– e.g. between shareholders (principals) and managers
(agents)
• Information asymmetries create much uncertainty
– transaction costs and information costs exist

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Agency relationship
• The ‘agency relationship’ is a central focus of agency
theory
• 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
• Agency theory key assumptions from the economics
literature, such as:
– 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

7-16
The agency problem
• At the core of the analysis is the ‘agency problem’
• The agency problem relates to issues associated
with motivating one party (the agent) to work in the
best interests of another party (the principal)
• Agency problems arise because of inefficiencies
and information asymmetries
• The agency problem leads to ‘agency costs’

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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 is used to address the
agency problem and to reduce agency costs
• Accounting is used as a monitoring and bonding
mechanism to control the efforts of self-interested
agents (managers)

7-19
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

7-22
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

7-24
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 and introduces inefficiencies

7-25
Opportunistic perspective
• Seeks to explain managers’ actions once contracts
are already in place
• That is, particular accounting methods might initially
be selected for efficiency reasons, but once they
have been negotiated/agreed, then managers will
aim to utilise accounting choices in a way that best
serves their own interest
• 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 continued

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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
• The decision to reward managers on the basis of
accounting profits might initially be introduced for
efficiency reasons (it motivates them to work in a
way that also benefits the principals), but it may
subsequently induce them to manipulate accounting
numbers (the opportunistic perspective)
– a change in 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

7-32
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

7-33
Use of conservative accounting methods
in management bonus schemes
• Conservative accounting methods, which would
include historical cost, tends to delay the recognition
of income, accelerate the recognition of expenses,
and lead to lower asset and higher liability recognition
• Asset and income recognition based on assessments
of fair value would not be considered a ‘conservative’
accounting approach
• Potential conflicts of interest between agents and
principals are better managed when conservative
accounting methods are used as they restrict the
ability of managers to opportunistically use income
and net asset increasing accounting methods

7-34
Market-based bonus schemes
• Apart from accounting-based bonus schemes,
managers are also often provided with capital
market-based bonuses
• May be more appropriate to remunerate managers in
terms of market value of firm’s securities (shares)
where accounting earnings fluctuate greatly
– e.g. mining, or high technology R&D firms
– or where managers are approaching retirement
• Methods include:
– cash bonus based on share price increases
– shares
– options to buy shares continued

7-35
Market-based bonus schemes (cont.)
• Providing managers with shares, or share options
creates incentives for managers to increase the
value of the firm – aligns their interests with those of
the owners (principals)
• But, 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
continued

7-36
Market-based bonus schemes (cont.)
• But remember, regardless of how managers are rewarded there is
always a maintained assumption within PAT that managers (and
everybody else) will be opportunistic
• Consider results of Bartov and Mohanram (2004):
– In presence of deteriorating profitability managers are likely to adopt
income increasing accounting methods to increase share prices and
therefore the value of their share options. They would then exercise their
share options thereby acquiring the shares, and fairly quickly sell the
shares before reported profits ultimately decline and the value of the
shares fall
• Aboody and Kasnik (2000):
– if managers know that share options were to be granted to them they will
disclose ‘bad news’ so as to reduce share prices and therefore the likely
future exercise price of the share options. This would mean that when
they ultimately exercise the granted options, thereby buying the
underlying shares, they will pay less and therefore make greater financial
gain

7-37
Choice of accounting versus
market-based bonus schemes
• Managers’ bonuses are 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

7-38
Debt contracting—agency
costs of debt
• Moving our attention to the relationship with
debtholders, in the absence of safeguards to protect
debtholders (creditors), managers are predicted to
adopt strategies to disadvantage the debtholders
• Agency costs of debt created by managers 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
(claim dilution)
– investment in high-risk projects may not be beneficial to debt
holders as they have a fixed claim (asset substitution)
– underinvestment

7-39
Use of debt contracts
• In the absence of safeguards to protect the interests
of debtholders from strategies such as those on the
previous slide, it is assumed the debtholders will
require the firm to pay higher costs of interest to
compensate for the risks
• That is, they will ‘price protect’
• If firms contract not to pay excess dividends, take on
high levels of debt, invest in risky projects, or under-
invest then they can attract debt at lower cost
• Hence, it is efficient to enter into contracts that
restrict the ability of managers to adversely affect the
wealth of debtholders

7-40
Evidence from 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
continued

7-41
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
continued

7-42
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
than private debt contracts – explained from an efficiency
perspective

7-43
The role of conservative accounting methods
in reducing the agency costs of debt
• As with management bonus schemes, it is believed that the use
of conservative accounting methods are relatively more
effective in reducing agency costs of debt
• Zhang (2008) suggests that from an efficiency perspective,
managers might agree to adopt conservative accounting
methods because it allows them to attract debt at a lower price
• The use of conservative accounting procedures means that
debt covenants restricting the amount of debt relative to assets
(or debt to equity), or the amount of times profits must cover
interest (known as an ‘interest coverage’ clause), will tend to be
more restrictive or binding compared to those organisations
that do not adopt conservative accounting methods.
continued

7-44
The role of conservative accounting methods in
reducing the agency costs of debt (cont)
• As Zhang (2008) argues, the more binding covenants will
provide an earlier warning of default risk, and will thereby
reduce the risk exposure of the lending party (for
example, a bank)
• The reason for this is that, because management will
have less ability to circumvent restrictive covenants (for
example, by undertaking asset revaluations), such
covenants will create a technical default of a loan
agreement earlier than if management has the scope to
loosen the restrictions
• The earlier the lender can take action to safeguard its
funds, the lower the risk to the lender

7-45
Debt contracts—manager’s
incentive to manipulate
• Ex post, the incentive to manipulate accounting numbers
increases as the accounting-based debt covenants 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
• But as we have learned, contracts that require the use of
conservative accounting methods reduce the ability of
managers to opportunistically manipulate accounting numbers

7-46
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

7-47
Political costs
• We have already indicated that financial accounting
numbers are important with respect to debt contracting
and management compensation contracting. Financial
accounting also plays a key role in the political process
• Political costs are 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

7-48
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

7-49
Actions of politicians
• Politicians know that highly profitable companies
could be unpopular with members of their
constituency
• Politicians (who are assumed to be driven by self-
interest like everybody else) could win votes by
taking actions against the companies
– argue that it is in public interest even though in own interest
• May rely on reported profits to justify actions
– provides incentives for firms to reduce reported profits

7-50
Example of how politicians use accounting
numbers as a means of justifying actions
against an organisation
• As reported in the Hobart Mercury on 9 March 2013, the Australian
Greens political party used the size of bank assets and profits as the
basis for levying additional taxes on banks. The article stated:
The Greens want a levy of 0.2 per cent on all bank assets above $100
billion in return for Federal Government guarantees, which the independent
Parliamentary Budget Office has costed as raising $11 billion over the next
four years.
“At a time when there's pressures on the budget, and the government is
looking around for ways of raising revenue, especially in light of the failed
mining tax, who can afford to pay it the most?" Australian Greens’ Mr Bandt
said yesterday.
"If we don't stand up to the big banks and the big miners, then the Labor
Party is going to come after the rest of us, like they have with single
parents, and like they are threatening with the forthcoming budget."
• As we can see, ‘profits’ are used to justify the proposed action. Lower
reported profits would provide less ‘ammunition’ for the politicians

7-51
Relevance of PAT-based research to current
efforts of IASB to promote use of fair values
• As already indicated in this lecture, conservative
accounting methods lead to:
– relatively lower revenue recognition
– faster expense recognition
– higher liability recognition
– lower asset recognition
• Historical cost accounting is a conservative approach
to accounting when compared to fair value
accounting
• Conservative accounting methods, such as historical
costs, reduce the ability of managers to manipulate
accounting numbers compared to fair value
accounting
continued

7-52
Relevance of PAT-based research to current efforts
of IASB to promote use of fair values (cont)
• Do the ongoing efforts of the IASB to embrace fair values
make sense from an efficient contracting perspective?
• Because conservative accounting methods reduce the
possibility that management will undertake opportunistic
earnings management, organisations that use
conservative accounting methods might be able to attract
debt and equity capital at a lower cost because of
perceptions about lower risk
• Applying this reasoning, numerous researchers argue
that the IASB and FASB should take note of the
advantages inherent in conservative accounting
procedures before finalising any judgements about
accounting measurement continued

7-53
Relevance of PAT-based research to current efforts
of IASB to promote the use of fair values (cont)
• Whilst information about fair values will be useful to
various financial stakeholders in terms of assisting them to
make informed investment/resource allocation decisions,
more conservative accounting methods also provide
benefits in terms of controlling potentially divergent
behaviour of individuals involved in various contractual
arrangements.
• There is a clear-trade-off between the advantages of
having relevant information about current values and the
contracting benefits that more conservative accounting
benefits provide

7-54
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

7-55
Diagrammatic summary of PAT

Deegan fat4e ppt_ch07

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