07 - Positive Accounting Theory.ppt

8/10/2019 07 - Positive Accounting Theory.ppt

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Positive AccountingTheory (PAT)



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People affect accounting

affects people’s behavior

Accounting



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Agency Theory

Principal Agent

Adverse Selection

Moral Hazard

Agency theory has been used to demonstrate:

Why it may be mutually beneficial to both partiesto have an auditWhy firms may lobby for certain accountingregulations



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Agency Theory Basics

Principal AgentDefinition A party who delegates others to

perform some service on his or herbehalf. The principal often contractswith an agent to safeguard and

enlarge a pool of assets which theprincipal owns and with which theagent is entrusted.

A party engaged as a steward toperform some service on the behalf ofothers, often involving safeguardingassets belonging to them. The

principals delegate decision makingauthority to the agent

AsymmetricInformation

Principal knows agent has access tosuperior information

Agent has access to superiorinformation

Moral hazard Principal incurs monitoring costs toattempt to make sure agent acts inappropriate ways

Agent may be able to act in waysunfavorable to or not approved by theprincipal – shirking, fraud, etc.

Monitoring costs a. Budget constraints, auditingb. Profit sharing, stock options andsimilar incentive plans to align agent’sself- interest with principal’s interests

Agents also benefit from monitoringactivities like an audit since suchdevices permit them to demonstrateeffective performance and chargemore for their services



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Owner-ManagerRelationship

Why won’t a fixed salary motivate hard work?

So, how would you motivate the work?

Give manager a share of the payoffBonus based on net incomeOwnership interest through optionsCombination?



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Positive Accounting Theory

Specific application of Agency Theory

Studies managers’ accounting policy choices,as part of the overall process of corporategovernance

That is, accounting policies are chosenstrategically

Positive (descriptive) rather than normative.Tries to understand and predict managers’accounting policy choices



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ASSUMPTIONS OF PAT

Firm is a nexus of contractsManagers are rational economic decision

makers Act to maximize their own utility, which maynot include the firm’s profits May be effort averse (lazy)

There are efficient markets for bothCapitalManagerial Labor



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Hypotheses of PAT

Bonus Plan HypothesisManagement chooses policies to shift earnings to improvetheir bonusCurrent earnings can go up or down

Debt Covenant HypothesisPolicies chosen to shift future earnings to avoid violation ofdebt contracts

Political Cost HypothesisDefer earnings from current to future to minimize political“heat”

Compliance HypothesisShift earnings to ensure that you meet regulatorrequirements



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Versions of PAT

Opportunistic VersionManagers choose accounting policies for

their own benefit

Efficient Contracting Version

Managers choose accounting policies toattain corporate governance objectives ofthe firm



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Distinguishing Opportunistic vs.Efficiency Versions of PAT

Per Scott Text: significant evidence infavor of efficiency version of PAT

This implies that the inherent conflictbetween investor and manager interests is

reasonably controlled



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Earnings Managment

Ways to Do ItChanging accounting policiesManaging discretionary accrualsTiming of adoption of new accountingstandardsChanging real variables--R&D, advertising,repairs & maintenanceStructured transactions like SPEsFraud like Worldcom capitalizing operatingexpenses



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Managing Earnings ThroughDiscretionary Accruals

NI = CFO ± Net Accruals

= CFO±

Net Non-DiscretionaryAccruals ± Net DiscretionaryAccruals

Examples of Discretionary AccrualsAllowance for doubtful accountsProvision for reorganization



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Estimating DiscretionaryAccruals, Cont’d

The Jones ModelTA jt = α j + β 1j ΔREV jt + ß 2jPPE jt + ε jt

This is the simplified version of the model.TA is total accruals orNet Income – Cash Flows

Discretionary accruals = Earnings Managementactual total accruals – predicted total accrualsThe ßs are coefficients to be estimated. Norelation to firm beta.



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Implications For Financial Accounting

Net income mattersWhy?Why would managers object to some newGAAP pronouncements?

The agency relationship is a contract

Contracts are rigidImplies accounting policy choice and changesto accounting policy matter



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Implications For Financial Accounting

To maintain market share, net income shouldbe correlated with manager effort

Historical cost accounting?

Fair value accounting?

Fundamental problem of current financialaccounting theory

Most useful net income for investors is notnecessarily the most highly correlated withmanager effort

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07 - Positive Accounting Theory.ppt