Positive Accounting Theory

ACCOUNTING THEORY AND PRACTICE PRACTICE FAR 600

Positive Accounting Theory

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By: Prof Madya Dr Roshayani Arshad Arshad Faculty of Accountancy UiTM

LEARNING OBJECTIVES  At the end of this lesson, students should be able to:

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Contracting theory  Agency theory Political processes

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POSITIVE ACCOUNTING THEORY

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To explain the reason for  observed practice

Why the economic consequences exist?

Which accounting policy firm will choose when some policies available

Concept of  PAT

To predict the actions of the firm What will the firm react to new acct standards? 4

ECONOMIC CONSEQUENCES Economic consequences is a concept that asserts that, despite the implications of efficient securities market theory, accounting policy choice can affect firm value. (Scott, W.R., 2003, p.259)

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Despite implications of efficient market theory, accounting policy choice have economic consequences for various constituencies of financial statement users Standard setting bodies includes different constituencies in their board in order to reach a consensus between 5 accounting and political demands.

THE RISE OF ECONOMIC CONSEQUENCES 

Economic consequences as defined by Zeff (1978) the impact of accounting reports on the decision-making  behavior of business, government and creditors.

(Scott, 2003,

 p.261)

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Third party interventions complicate the setting of  accounting standards because they try to influence or  influenced the accounting the standard setting bodies

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Example: attempt by several US corporations to implement replacement cost accounting during the period of high inflation (1947-1948) 6

THE RISE OF ECONOMIC CONSEQUENCES 

Since there is no theory that clearly prescribes what accounting policies should be used other  than a vague requirement tradeoff between relevance and reliability is necessary

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This opens the door for various other  constituencies to argue for their preferred accounting policies

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Hence standards setting requires both the accounting theory domain as well as the political domain 7

PHILOSOPHY OF PAT  A science to predict unobservable phenomena and

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seeks to explain observed accounting phenomena by searching for the reasons events occur  ‘The objective of (positive) accounting theory is to explain and   predict accounting practice … Explanation means providing 

reasons for observed practice. For example, positive accounting theory seeks to explain why firms continue to use historical coat accounting and why certain firms switch between a number of  accounting techniques. Prediction of accounting practice means that the theory predicts unobserved phenomena. (Watts & Zimmerman, 1986, p.2) 8

PHILOSOPHY OF PAT 

Economic focus 

i.e., focus on the costs and benefits of the alternative accounting methods, regulations & accounting std setting process & the effects of reported FS on share prices.

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More scientific in methodology i.e., empirically explaining & predicting what occurs.

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Central idea is to develop hypotheses about factors that influence the world of accounting practices and to test the validity of these hypotheses empirically.

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N ATURE OF NORMATIVE THEORY & ITS LIMITATIONS 

Prescribes what should occur or the best way to account

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Limitations 

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Normative presupposes PAT (Jensen, 1983) Normative not based on identified, empirical observations & methods (Watts & Zimmerman , 1986) 

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‘Valid prescription requires specification of both an objective and  an objective function.’ (p.7)

Normative produces irrefutable prescriptions

(Popper, 1968)

‘No amount of empirical testing can prove a theory to be correct   – i.e. tests of a theory against real-world data - but a theory  10 should be refutable or capable of falsification.’

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SCOPE OF PAT Positive Accounting Theory

Capital Market Research (CMR)

Efficient market hypothesis (EMH) Capital Asset Pricing Model (CAPM)

 Accounting Policy Choice (APC)

Opportunistic reasons Efficiency reasons

Cop yrig ht@ 2004 by Roh ana Oth man. All

SCOPE OF PAT 

PAT attempts to understand & predicts firm’s APC

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PAT asserts that firms need APC to minimize contracting costs

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PAT implies it is more efficient for firm to have a set of accounting policies (GAAP) from which management can choose

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However, this flexibility in APC opens the door Cop to yrig ht@ opportunistic management behavior  2004 by Roh ana Oth man. All

SCOPE OF PAT 

Efficiency assume that internal control systems limit opportunism and motivate managers to choose accounting policies that minimize contracting costs.

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Sweeney (1994) found that managers change accounting policies only when it was cost effective & Dechow (1994) further confirmed Sweeneys’ findings.

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Both the above studies confirmed that managers choose accounting policies more for efficiency reasons rather opportunistic reasons.

Cop yrig ht@ than 2004 by Roh ana Oth man. All

SCOPE OF PAT 

PAT developed in two stages 

First-stage literature did not explain accounting practice. The earlier of the two stages involved research into accounting and the behaviour of capital markets

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Second-stage literature sought to explain and predict accounting practices across firms

Cop yrig ht@ 2004 by Roh ana Oth man. All

THE DIFFERENCE BETWEEN NORMATIVE THEORY AND POSITIVE THEORY Normative theory: what they should do  What is a good normative theory: it is judged by its logical consistency with underlying assumptions of how rational individuals should behave  Positive theory: to predict which acct policy firms will choose 

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THE RELATION

BETWEEN NORMATIVE THEORY AND POSITIVE 

Both are valuable to theory development and testing

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Positive theory helps to keep the normative research on track by empirical testing

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STRENGTH OF PAT Perceived that theory should be able to generate hypotheses capable of  falsification through empirical testing Deemed desirable that theory aim was to explain and predict accounting practices rather than supply prescriptions Necessary to rationalize existing accounting principles, which normative theory didn’t attempt to do PAT attempt to model connection between accounting, firms, & markets & analyze problems within an economic network

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WHY PAT? 

What was? What is? What ought to be?

 A theory that is consistent with the existence of  economic consequences

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explain or predict real world phenomenon and are tested empirically

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Based on scientific methodology using economic based empirical literature

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Enable theories to be refuted, to explain & predict, to rationalize accounting principles and to model connection between accounting, firms & markets

 Attempt to understand why accounting policies matter  18 and predict which accounting policies firms will choose

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PAT HYPOTHESES 

Predictions made by PAT largely organized around 3 hypotheses formulated by Watts & Zimmerman (1996), all other things being equal: The Bonus Plan Hypothesis 

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The Debt Covenant Hypothesis 

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Choose accounting policy that shift reported earnings from future periods to the current period Firm with prospect of violating accounting-based debt covenants (e.g. going below the agreed specified level of debt equity ratio) would shift reported earnings from future periods to current periods

The Political Cost Hypothesis 

Choose accounting policy that defer reported earnings from current to future periods.

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PAT HYPOTHESES 

Managers of firms with bonus plan predicted to 

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Managers of firms with high debt-to-equity ratio 

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choose less conservative accounting policy & oppose accounting standards that may lower reported net income than managers of  firms without such plan

Choose less conservative accounting policy & oppose new standards that may lower reported net income.

Managers of large firms 

Choose more conservative accounting policies & less likely to oppose new standards that may lower reported net income.

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POSITIVE THEORIES 

‘Experiences’ or ‘facts’ of the real world

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explaining reasons for current practice

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predicting how accounting information is used in economic decision-making

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N ATURE OF POSITIVE THEORIES 

Provide description of what accounting is

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Descriptive, inferential & objective

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Objective of PAT is to explain & predict accounting practice

 A science to predict unobserved phenomena

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Observable & verifiable

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Derived inductively from specific set of  observation

 Analytic (logic), semantic & pragmatic

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N ATURE OF POSITIVE THEORIES Based on scientific empirical methodology, relating or  testing accounting hypothesis to experience or facts of  real world e.g., efficient market hypothesis  Focus on 

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 Accounting policy choice Capital market research

 Assumptions

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Efficient capital market  A firm is a nexus of contracts  Accounting is important in contract enforcement  Accounting information is an economic good Managers, investors, lenders & others are assumed to be rational & evaluative utility maximizer  Discretion to choose accounting policies that maximize their  utility and value of firm

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CRITICISMS ON PAT 

Positive theory are not value free

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VALUE FREE IS NOT ALTERED OR INFLUENCED BY VALUE JUDGMENT

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Value judgment of the rightness or wrongness or  usefulness of something base on persona; view.

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The theories use large-scale statistical research, remote from practitioners and their concerns 24

DIFFERENCE BETWEEN NORMATIVE & POSITIVE ACCOUNTING THEORIES Normative 

Prescriptive 

Prescribed how people should behave

Positive 

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Descriptive, explanatory or predictive 

Describe how people behave

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Explain why people behave in a certain manner 

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Predict what people have done or will do

Suggestion: can coexist & complement each other 

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CONTRACTING THEORY Firm is a legal nexus (connection) of contractual relationships

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amongst suppliers and consumers of factors of production 

Rationale for the firm: ‘it costs less to transact (or contract) through central organization than to do so individually’  ‘firm is an efficient means of organizing economic activity because they reduce contracting costs’ Hence firm exists to reduce transaction costs

PAT-APC focuses on two main types of agency contracts to explain

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accounting practices: 

Management contracts (shareholders & managers)

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Debt contracts (lenders & managers who is acting on behalf of the shareholders)

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 AGENCY THEORY 

Developed to explain & predict the actions of agents (e.g. managers) & principals (e.g. shareholders or  lenders).

 Assumption: no ‘ a priori’ reason to believe that agent will act in the best interest of the principal

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Jensen & Meckling (1976) describe an agency relationship arises when there is a contract under which one party (the principal) engages another party (the agent) to perform some service on the principal’s behalf.

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Under the contract the principal delegates some decision-making authority to the agent

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 AGENCY THEORY – PROBLEM 

No reason to believe that the agent will always act in the principal’s best interests.

 Agency problem is the problem of inducing an agent to

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behave as if he or she were maximizing the principal welfare, resulting in agency cost

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 AGENCY THEORY - COSTS  Agency costs are costs that arises from agency relationships (because of the separation of  ownership from control of an entity)

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Three types of agency costs identified are: 

Monitoring costs

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Bonding costs

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Residual loss

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 AGENCY THEORY - MONITORING COSTS 

Costs of monitoring the agent’s behavior 

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Expenditure by principal to measure, observe & control agent’s behavior 

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Examples: mandatory audit costs, cost to establish management compensation plan, & budget restrictions among others

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Price protection is the way the principal protects against agency costs by paying according to the level of costs expected.

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Price protection is borne by agents 30

 AGENCY THEORY - BONDING COSTS 

Costs of establishing & complying with mechanisms (bonding agent’s interest with the principal’s interest)

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Borne by agents - Price protection resulted in agents ultimately having to bear monitoring costs associated with contracts

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Examples: frequent quarterly financial statements

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Costs to managers includes: time & effort, constraints, & income forgone 31

 AGENCY THEORY – RESIDUAL LOSS 

Residual loss occur when the net value of the agents’ output is less, when they make decisions that are not entirely in the principal’s interest (deadweight loss)

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When the agent make decisions that do not keep the best interest of the principal, it results in residual loss

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Strong form efficient market provide information on incentives & opportunities that will trigger the agent to act contrary to the interest of a principal

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The agent would then use information to set their  remuneration level i.e., the principal will remunerate the agent to the point that the principal expects the agent to likely become contrary to the interest of the principal

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Principal is price protected

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 AGENCY THEORY – SETTLING UP 

Settling up means the principal review the remuneration package given to the agent base on the principle that the remuneration level has to tally with the agent’s effort.

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If the agent is deemed to have acted more in favor of  the interest of the principal the it is likely that the remuneration will be revised upwards

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In contrary, remuneration will revise downwards if the agent is deemed to have acted more in contrary to the interest of the principal

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If the contract is to be continued then it should start with 33 the remuneration decided upon at the settling up

 AGENCY THEORY – RESIDUAL OPPORTUNISM 

Residual opportunism – cost borne by agent due loss of reputation & potential loss of long-term returns to them

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With incomplete price protection & settling up, residual loss is borne partly by agent & partly by principal

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 AGENCY COSTS 

Monitoring costs 

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Bonding costs 

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Cost of monitoring agents behaviour and expenditure by principal to measure, observe and control the agent’s behaviour. Examples: audit costs, operating rules, budget restrictions Costs of establishing and complying with these mechanism (bond’s agents interest to match principal’s interest). These costs are borne by agents Examples: frequent (weekly, quarterly, semi-annually) reporting to shareholders

Residual costs 

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 Also known as deadweight loss is when the net value of the agent’s output is less than if the agent’s interest were completely aligned to the principal Not reduced by monitoring or binding costs However, under strong-form efficient market, it is assumed that the firm can be price protected in the form of agent’s remuneration 35

 AGENCY PROBLEM AND COST  Agent problem and cost arise from the opportunistic behaviour of management  Opportunistic tendencies increase with decrease proportionate share (ownership) which increases residual loss.  Shareholders are prepared to bear agency costs as long as marginal benefits to shareholders exceed marginal cost  Price protection of shareholders could be in two forms: 

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Share price adjustments to reflect opportunistic behaviour 

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Share price exclude monitoring and binding cost

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Limitation of price protection is that share price is not always available due to thin trading and when manager’s efforts can be directly related to earnings performance 36

SUMMARY  A number of conflicting theories have developed

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 A theory generally consists of  three parts

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There are several criteria for judging a theory

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Persuasiveness of evidence

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