07 - Positive Accounting Theory.ppt

Positive Accounting Theory (PAT)

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affects people’s behavior   Accounting

People affect accounting 2

 Agency Theory Moral Hazard

Principal

Agent

 Adverse Selection 

 Agency theory has been used to demonstrate: 

Why it may be mutually beneficial to both parties to have an audit

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Why firms may lobby for certain accounting regulations 3

Agency Theory Basics Principal Definition

Asymmetric Information Moral hazard

Monitoring costs

 A party who delegates others to perform some service on his or her behalf. The principal often contracts with an agent to safeguard and enlarge a pool of assets which the principal owns and with which the agent is entrusted. Principal knows agent has access to superior information Principal incurs monitoring costs to attempt to make sure agent acts in appropriate ways a. Budget constraints, auditing b. Profit sharing, stock options and similar incentive plans to align agent’s self-interest with principal’s interests

Agent  A party engaged as a steward to perform some service on the behalf of others, often involving safeguarding assets belonging to them. The principals delegate decision making authority to the agent  Agent has access to superior information  Agent may be able to act in ways unfavorable to or not approved by the principal – shirking, fraud, etc.  Agents also benefit from monitoring activities like an audit since such devices permit them to demonstrate effective performance and charge more for their services

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Owner-Manager Relationship 

Why won’t a fixed salary motivate hard work?

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So, how would you motivate the work?

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Give manager a share of the payoff 

Bonus based on net income

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Ownership interest through options

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Combination? 5

Positive Accounting Theory 

Specific application of Agency Theory

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Studies managers’ accounting policy choices, as part of the overall process of corporate governance 

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That is, accounting policies are chosen strategically Positive (descriptive) rather than normative. Tries to understand and predict managers’ accounting policy choices 6

 ASSUMPTIONS OF PAT Firm is a nexus of contracts  Managers are rational economic decision makers 

 Act to maximize their own utility, which may not include the firm’s profits  May be effort averse (lazy) 

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There are efficient markets for both Capital  Managerial Labor 

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Hypotheses of PAT 

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Bonus Plan Hypothesis  Management chooses policies to shift earnings to improve their bonus  Current earnings can go up or down Debt Covenant Hypothesis  Policies chosen to shift future earnings to avoid violation of debt contracts Political Cost Hypothesis  Defer earnings from current to future to minimize political “heat” Compliance Hypothesis  Shift earnings to ensure that you meet regulator requirements

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Versions of PAT 

Opportunistic Version 

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Managers choose accounting policies for their own benefit

Efficient Contracting Version 

Managers choose accounting policies to attain corporate governance objectives of the firm 9

Distinguishing Opportunistic vs. Efficiency Versions of PAT 

Per Scott Text: significant evidence in favor of efficiency version of PAT

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This implies that the inherent conflict between investor and manager interests is reasonably controlled

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Earnings Managment 

Ways to Do It 

Changing accounting policies

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Managing discretionary accruals

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Timing of adoption of new accounting standards

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Changing real variables--R&D, advertising, repairs & maintenance

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Structured transactions like SPEs

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Fraud like Worldcom capitalizing operating expenses 11

Managing Earnings Through Discretionary Accruals

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NI = CFO ± Net Accruals = CFO ± Net Non-Discretionary Accruals ± Net Discretionary Accruals

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Examples of Discretionary Accruals 

Allowance for doubtful accounts

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Provision for reorganization 12

Estimating Discretionary Accruals, Cont’d 

The Jones Model   

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TA jt = α j + β1j ΔREV jt + ß2jPPE jt + ε jt This is the simplified version of the model. TA is total accruals or Net Income – Cash Flows

Discretionary accruals = Earnings Management  

actual total accruals – predicted total accruals The ßs are coefficients to be estimated. No relation to firm beta. 13

Implications For Financial  Accounting 

Net income matters  

Why? Why would managers object to some new GAAP pronouncements?

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The agency relationship is a contract

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Contracts are rigid 

Implies accounting policy choice and changes to accounting policy matter 14

Implications For Financial  Accounting 

To maintain market share, net income should be correlated with manager effort  

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Historical cost accounting? Fair value accounting?

Fundamental problem of current financial accounting theory 

Most useful net income for investors is not necessarily the most highly correlated with manager effort 15