Financial Accounting Theory Craig Deegan Chapter 7

Financial Accounting Theory Craig Deegan

Chapter 7 Positive accounting theory Slides written by Craig Deegan and Michaela Rankin

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Learning objectives • In this chapter you will be introduced to  – how a positive theory differs from a normative theory  – the origins of Positive Accounting Theory (PAT)  – the perceived role of accounting in minimising the transaction costs of an organisation  – how accounting can be used to reduce the costs associated with various political processes  – how particular accounting-based agreements with parties such as debtholders and managers can provide incentives for managers to manipulate accounting numbers  – some criticisms of PAT

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Positive compared to normative theories •  A positive theory theory seeks to explain and predict predict particular phenomena • Normative theories prescribe how a particular practice should  be  be undertaken  – the prescription might depart from existing practice

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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)

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Positive accounting theory defined (cont.) • Focuses on relationships between various individuals and how accounting is used to assist in the functioning of these relationsh relationships ips • Examples of relationships  – owners and managers  – managers and the firm’s debt providers

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Assumptions underlying PAT •  All individuals’ individuals’ action is driven by self  self -interest -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 PAT • Started coming to prominence in mid-1960s  – paradigm shift from normative theories

• dominant research paradigm in 1970s and 1980s  – shift resulted from US reports on business education, and improved computing facilities enabling large-scale statistical analysis

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Origins of PAT—capital markets research • Development of Efficient Markets Hypothesis (EMH) by Fama and others  – 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

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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 announceme nts impacted share prices  – evidence that historical cost information is useful to the market

• Literature unable to explain why particular accounting methods selected

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Origins of PAT—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 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 decisionmaking authority to the agent’

• Relies on traditional economics literature  – 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 will therefore have incentives incentives to enter contracts which appear to limit actions detrimental to agents

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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  Accounting information used to reduce agency agency costs • Used as monitoring and bonding mechanisms to control the efforts of self-interested agents

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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

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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

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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

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Opportunistic perspective • Seeks to explain managers’ actions once contracts are already in place • Not possible to write complete contracts, so managers are assumed to opportunistically 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, self-interest, owners owners expect managers 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

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Owner/manager contracting (cont.) • In the absence of controls to reduce opportunistic behaviour, agents (managers) expected to undertake activities disadvantageous 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— 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 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 changes in accounting accounting methods will affect 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 • Rewarding managers on the basis of accounting profits may induce them to manipulate accounting numbers (the opportunistic perspective perspective))  – 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

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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 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

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Market-based bonus schemes • May be more appropriate to remunerate managers in terms of market value where accounting earnings fluctuate greatly  – e.g. mining, or high technology R&D firms

• Methods include  – cash bonus based on share price increases  – shares  – options to shares

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Market-based bonus schemes (cont.) • Managers have incentives to increase the value of the firm • 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

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Choice of accounting versus marketbased bonus schemes • 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 marketmarket wide movements in equity values

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Debt contracting—agency costs of debt •  Agency costs costs of debt include 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 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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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

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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

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Debt contracts—manager’s incentive 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 • Consider HIH • Too costly to stipulate all acceptable accounting methods in contract so managers always have some discretionary ability

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Role of external auditors •  Auditors arbitrate on the reasonableness 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

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Political 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

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Political actions of individuals • Limited expected ‘pay‘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

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Actions of politicians • Politicians know that highly profitable companies could be unpopular with members of constituenc constituency y • Politicians could win votes by taking actions against the companies  – argue that in public interest even though in own interest

• May rely on reported profits to justify actions  – provides incentives for firms to reduce reported profits

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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 simplistic a perspective of humankind • Issues have not shown great development • In undertaking large-scale empirical research, researchers ignore organisati organisational-specific onal-specific relationships

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