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ACCT3003ACCT3003Issues in Accounting Issues in Accounting

TheoryTheory

Topic 5Positive accounting theory

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Positive compared to normative Positive compared to normative theories 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

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Assumption underlying PATAssumption 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

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Origins of PATOrigins of PAT——capital markets capital markets researchresearch

•Development of Efficient Markets Hypothesis (EMH) by Fama and others▫capital markets react in an efficient

and unbiased manner to publicly available information

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Agency theory Agency theory

•Explained why the selection of particular accounting methods might matter

•Focused on the relationships between principals and agents▫e.g. shareholders and managers

• Information asymmetries create much uncertainty▫transaction costs and information costs

exist

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Agency relationshipAgency 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 on traditional economics literature▫assumptions of self-interest and wealth

maximisation

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Price protectionPrice 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 principals

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Agency costsAgency 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 Role of accounting in contracts contracts

•Accounting information used to reduce agency costs

•Used as monitoring and bonding mechanisms to control the efforts of self-interested agents

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Key hypothesesKey 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 hypothesisBonus 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 hypothesisDebt 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

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Political cost hypothesisPolitical 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 Two perspectives adopted by PAT researchresearch

•Efficiency perspective•Opportunistic perspective

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Efficiency perspectiveEfficiency perspective

•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

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Opportunistic perspectiveOpportunistic 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

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Owner/manager Owner/manager contractingcontracting

• 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

• 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

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Bonus schemesBonus 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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Debt contracting—agency costs of Debt contracting—agency costs of debtdebt

•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

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Use of debt contractsUse 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

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Debt contracts—manager’s Debt contracts—manager’s incentive to manipulateincentive 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

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Political costsPolitical 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