Positive accounting theory (pat) Bonus Plan Hypothesis , Debt Covenant Hypothesis ,Political Cost Hypothesis

POSITIVE ACCOUNTING THEORY (PAT)

BONUS PLAN HYPOTHESISDEBT COVENANT HYPOTHESISPOLITICAL COST HYPOTHESIS

Group Members :-

1) Maznah Binti Zakaria (P63559)

2) Nur Asiah Binti Abd.Rashid (P63558)

3) Maryam Youssefinejad (P64537)

1) 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

Positive Accounting

Theory

Efficiency Perspective

Opportunistic Perspective

Bonus Plan Hypothesis

Debt Covenant

Hypothesis

Political Cost Hypothesis

INTRODUCTION (continue)

BONUS PLAN HYPOTHESIS

INTRODUCTION

1) 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.


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

INTRODUCTION

1) 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. [2000]).


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 [1992]; Krishnan & Kumar [2001]), and

9) 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 [1976]; Fama & Jensen [1983]).





COMMAND HIGHER LEVELS OF COMPENSATION FOR THE INFORMATIONAL ADVANTAGES• CEOs provide on investment

projects and increased risk exposure related to investment opportunities

TO REDUCE AGENCY COSTS ARISING FROM INFORMATIONAL ASYMMETRY• to tie CEO compensation closely to

managerial efforts of accomplishing investment goals in the best interest of their shareholders

HIGH-TECH FIRMS INCUR LARGE EXPENSES TO GENERATE AND EXPLOIT INVESTMENT OPPORTUNITIES THAT POTENTIALLY LOWER ACCOUNTING EARNINGS. • 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.

WHY HIGH-TECH FIRMS USE THE COMPENSATION INSENTIVES (DISCRETIONARY ACCRUAL)



TO ACHIEVE THE EARNINGS BENCHMARK• since significant economic

benefits potentially accrue to firms when earnings meet or beat analysts’ forecasts.

HIGHER LEVELS OF VOLATILITY IN TECH STOCK PRICES • mean that shareholders of high-tech

firms are more likely to experience a large decline in wealth at some time.

• In response to these pressures, compensation committees are likely to reward executives who use discretionary accruals to match analysts’ forecasts.

TO MEET OR BEAT ANALYSTS’ EXPECTATIONS AS AN IMPORTANT ASPECT OF PERFORMANCE.• The accrual process allows CEOs to

exercise judgment in communicating private information about the future prospects for their firms (Healy & Palepu [1993];

• Dechow [1994]). Guay, Kothari, and Watts (1996) 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.

TO INFLUENCE INVESTOR PERCEPTION OF THE FIRM VALUE• when discretionary accruals convey

relevant information about performance and

• when CEOs use discretionary accruals to prevent large declines in stock prices by meeting or beating analysts’ forecasts.

WHY HIGH-TECH FIRMS USE THE COMPENSATION INSENTIVES (USE DISCRETIONARY ACCRUAL)



RESEARCH OBJECTIVE

1) 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.

• High-tech firms pay higher levels of executive compensation than low-tech firms.

HYPOTHESIS

• High-tech firms pay less in cash salaries and bonuses but offer more stock options than low-tech firms.

HYPOTHESIS

• The association between changes in compensation and changes in stock performance is higher, and the association between changes in compensation and changes in accounting performance is lower, for high-tech firms than for low-tech firms.

HYPOTHESIS

• The association between compensation and discretionary accruals is higher in high-tech firms than in low-tech firms, especially when earnings before discretionary accruals are lower than analysts’ earnings forecasts.

HYPOTHESIS



SIZE EFFECT

• compensation relates to firm size:• large firms

typically have more complex structures and require a greater level of managerial effort than small firms.

• Even though firm size does not differ 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.

REGULATION EFFECT

• executive compensation varies inversely with levels of regulation because regulations restrict the chief executive officer’s investment discretion and reduce the marginal product of the decision maker.

DEBT EFFECT

• Debt to-asset ratios differ significantly between high-tech and low-tech firms, so it is particularly important to control for the effect of debt.

SENSITIVITY TEST (CONFOUNDING FACTORS





CONCLUSION

1) 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 CEOs

3) 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 groups

4) 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.

CONTRIBUTION

Provide evidence that industry membership, that is, high-tech versus low-tech, has incremental contracting value in

determining executive compensation beyond the IOS

Demonstrate that compensation committees use compensation

contracts to encourage CEOs to use discretionary accruals to

improve the ability of earnings to reflect the economic value of

high-tech firms, especially when information asymmetry is high. The results of this study support the agency cost explanation of

corporate policy choices.

Suggest that the increasing number of high-tech firms and those firms’ need to change compensation

strategies to use more stock-based compensation as business environments become more uncertain



DEBT COVENANT

HYPOTHESIS

DEBT COVENANT HYPOTHESIS

Debt 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. Nikolaev

Author : 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 COVENANTS

Timely 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 contracting are

need(Watts and

Zimmerman, 1986),

Therefore , lead to increase demands

for timely recognition of

economic losses in accounting

earning.

ECONOMIC DIFFERENCES EXIST BETWEEN :-

Private Debt(bank loan)

• Consider superior monitor – direct access to internal information

• Maintain certain financial ratio – tighter range• result to covenants

violations and subsequent renegotiation

• Private debtholder control. Thus, reduce scope of managerial opportunism

• Usually require quarterly compliance covenants

Public Debt(bonds)

• Seldom require maintenance of accounting ratio – due to higher renegotiation cost associate with diffuse ownership.

• Require annual compliance certification

• Thus be more concern than private lender with the degree of timely recognition of losses.

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

Argue that debt market influence the degree of accounting conservatism. However the evidence is largely limited to cross-country and cross market explanations. (Watts and Zimmerman, 1986; Ball, Kothari, and Robin, 2000; Watts, 2003a,2003b; Ball and Shivakumar,2005; Ball and Sadka, 2008)

o Under same GAAP jurisdiction and capital structure - the design of debt contract has an incremental effect on reporting incentives

o Document the link timely loss recognition and public debt covenants.

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.

THE POLITICAL COST

HYPOTHESIS

FIRM-STAKEHOLDER INTERACTION-PERSPECTIVES

Firm-stakeholder interaction-perspectives

Positive perspectives

Positive /normative

perspectives

Normative perspectives

Aida in interpretation of theory

Theories

Shareholder

power

Agency theory

Instrumental stakeholder theory

Positive accounting theory : the political cost hypothesis

Stakeholder agency theory

Stakeholder Perspective

Underlying Notion

Characteristics

The Political Cost Hypothesis (PCT)

Reaction of the firm to the possibility of 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.

Regulatory Wealth Effects

THEORETICAL PERSPECTIVES OF THE FIRM-STAKEHOLDER RELATIONSHIP

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’s

economic, 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 real estate market as samples for political

costs.

The political cost hypothesis is one of the three basic hypothesis 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 (Western countries)

Emerging market(China

)

compare

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 to control real estate prices to achieve a more reasonable price

level ..

Being subject to more stringent regulations and public scrutiny , real estate companies are likely to adopt earnings decreasing

accounting 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 .

To avoid

Doing an empirical study to determine whether the political costs hypothesis is applicable to China , the results show that , with the implementation 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 provide

an incentive for earnings management , which is different from the effects 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

between different 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 .

Company Size Early research like watts and zimmerman found

that , compared with small companies , large companies are more likely to accept General Price

Level Adjusted (GPLA) accounting standards , because profits adjusted by the guidelines are

lower than unadjusted profits . They analyze the reasons for this phenomena and 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.

ALTERNATIVE MEASURE OF POLITICAL COSTS

Corporate Tax RatesAre also an important alternative measure of

political costs . Corporations that are free from political involvement generally have lower tax rates . Alternatively , companies with higher

profits are more easily identified by governments and tend to have higher tax rates . Therefore ,

enterprises have motives to reduce the amount of tax payable .

STAKEHOLDERS LEGITIMATE RIGHTSSTAKEHOLDERS INTRINSIC VALUE

Han 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 for the 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 forth

quarters to reduce the high political costs associated with this large abnormal growth in income .

EXAMPLE FOR CORPORATE TAX RATES

To resolve this problem , we should understand the political and

economic differences between China and the West .

Western Countries China

Political power belongs to the elected parliament

Power is distributed among 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

FIRST : RELATES TO THE SYSTEM OF GOVERNANCE

Western Countries China

The main purposes are to avoid monopolies , protect the environment or increase tax revenues

This aims are realized by regulating certain characteristics of large corporations

The goal of emerging countries is not to limit the scale of companies , but to encourage them to become stronger and more competitive

SECOND : POLITICAL REASONS FOR MANAGING

THE ECONOMY

Economic stability is also very important for this emerging and transforming nation

THIRD : the objective of the government’s economic management . There are few state-owned companies in the West , but there are many large state-owned companies in China .and non-state-owned companies are affected by government economic management more than state owned companies .

THE LAST DIFFERENCE : the forms of economic management .It is significant that the Chines economy stated from a planned economy . Thus , the government is used to implementing industrial policies . When a company’s development matches the government's industrial policies , it will be encouraged.

In summary , China is an emerging country in the process of economic transition . The political costs of companies in China are quite different from those faced by companies in Western countries .

These differences are reflected in many aspects of the system of government , • The motivation for governing • The form of government• The different circumstances that are subject to

economic control

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 real

estate market , its development and change now affect not only financial security and social stability , but also the health of the

entire national economy .

RELATIONSHIP BETWEEN EARNING MANAGEMENT BEHAVIOUR AND POLITICAL COST IN AN EMERGING

MARKET

The importance of the real estate industry is beyond question and it is also undoubtedly within the scope of intervention . When house prices rise too fast and cause broad public concern or even threaten macroeconomic stability , the government can take necessary measures to manage the real estate industry .

Between 1994 and

1997

The real estate market stagnated

Between 1998 and 2002

China carried out a series of policies to

support and encourage the growth of the real

estate industryAfter 2001 the real

estate industry in China gradually entered a

trend of rapid growth

In 2003 real estate investment in china increased by 30.33%

compared to the previous year

In the same year house price rose much faster

than in past years

In 2005 the prices for condominiums

increased

In early 2006 house price soared in cities

Accordingly , the sharp rise in house

prices

These macroeconomic controls had a long-term impact and deeply affected the real estate industry. The policies were based

on 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.

Using a sample of listed real estate companies between 2002 and 2007, we conduct an empirical study of the political

costs hypothesis for earnings management in the context of China. The results show that, to avoid the negative impact of

tightening government policies, listed real estate companies have an incentive to decrease current earnings. The motivation

to conduct earnings management is greater for non-state-owned real estate companies than state-owned companies. However,

we do not find evidence that ordinary state-owned enterprises are more sensitive to political costs compared to central

government enterprises. The results of our study demonstrate that close attention needs to be paid to economic indicators

that act as references for macroeconomic controls when conducting earnings management research in the context of China.

CONCLUSION , LIMITATION AND FUTURE RESEARCH DIRECTIONS

Our first contribution to the earnings management literature is that company size, commonly used as a proxy for politicalcosts in traditional Western research, does not apply in the context of China. Economic indicators that act as references tomacroeconomic controls may be more accurate. Second, we test for differences in political cost sensitivity in different typesof corporations, thereby enriching the approach to political costs research in China. Our findings provide a reference for governmentindustrial policy during transition periods.


There are a number of limitations to this study. First, we created new variables as proxies for political costs that have

never been used in previous studies. We do not study the importance of real estate prices for government regulation or

how political costs are applied to the real estate industry. Further research is needed in this field, for example, to examine

whether the ease of re-financing and the level of tax incentives play important roles in earnings manipulation. Second, our

political cost indicator is limited to the macroeconomic level and we fail to identify the political costs of individual companies.

In addition, as there are a variety of real estate price indexes, it may be questionable whether our indicator is the most

appropriate. 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, these limitations all provide directions for future

research.


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Documents

Positive accounting theory (pat) Bonus Plan Hypothesis , Debt Covenant Hypothesis ,Political Cost Hypothesis