Chapter 8 Flashcards
Positive accounting theories - definition
Theories that seeks to explain and predict particular phenomena ( contrast to normative theories which prescribe how a particular practice should be undertaken)
Positive Accounting Theory (PAT) - definition
Watts and Zimmerman - Explains 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
Assumptions underlying PAT
- alla individuals are driven by self-interest and they will all act in a opportunistic
- Organisations will seek to put in place mechanisms that align the interest of the managers (the agents) with the interest of the owners (the principals)
Origins of PAT - start
Became the dominat research paradigm in 1970s and 1980s because of improved computing facilities enabling large-scale statistical analysis (positive research)
Origins of PAT - EMH
Efficient Markets Hypothesis (Fama) provided an environment suitable for PAT research. Based on the assumption that capital markets react in an efficient and unbiased manner to publicly available information.
- Ball and Brown - earnings announcements impacted share prices
Origins of PAT - Agency Theory
Crucial to the development of PAT.
Explained why the selection of particular accounting methods matter, focused on the relationship between principals and agents.
Information asymmetries
Situation where one party in a transaction has access to certain information that is not available to the other party to the transaction, create much uncertainty
Agency relationship
a contract under which one or more (principals) engage another person (agent) to perform some service on their behalf which involves delegating some decision-making authority to the agent
Key assumptions agency theory
- self-interest
- wealth maximisation
The agency problem
Issues associated with motivating one party (the agent) to work in the best interests of another party (the principal). Arises because of inefficiencies and information asymmetries.
Leads to agency costs.
The different agency costs
- Monitoring costs - costs of monitoring agents´behaviour
- Bonding costs - costs involved in agents bonding their behaviour to expectations of principals. Occurs when the agent gives a guarantee to undertaken certain activities
- Residual loss - too costly to remove all opportunistic behaviour, not all agency costs can be addressed
3 key hypotheses frequently used in PAT literature to explain, and predict support oropposition to, an accounting method (Watts & Zimmerman):
- Bonus plan hypothesis
- Debt hypothesis
- Political cost hypothesis
Bonus plan hypothesis
Managers with bonus plans (tied to reported income) are more likely to use accounting methods that increase current period reported income
Debt hypothesis
Proposes that organisations close to breaching accounting-based debt covenants will select accounting methods that lead to an increase in profits and assets
Political cost hypothesis
By presenting lower adjusted profits, large organisations would attract less political attention and hence there would be less likelihood that parties would attempt to transfer wealth away from the organisation (tax)
2 Perspectives adopted by PAT research
- Efficiency perspective - (Ex ante) managers will elect to use a method that provides the most efficiently record of how the organisation performed
- Opportunistic perspective - (Ex post) managers will select a method that increases profit and therefore to an increase in their bonus, happens after contractual arrangements have been put in place (agency costs eliminated)
Bonus schemes
A method of rewarding managers where remuneration can be tied to:
- profits
- sales
- return on assets
Earnings management - definition
Where managers adopt particular accounting policies, or make accounting-based decisions primarily to generate desired measures of profits/earnings.
Can also occur when managers decides to undertake, or not undertake, certain transactions
“Accrual-based earnings management”
Earnings management can be undertaken as a result of making various discrentionary accruals of income or expenses
“Real earnings management”
Earnings management can be come about as a result of selectively undertaking actual transactions near the end of the financial year
Some criticisms to positive accounting theory
- does not provide prescription
- have not shown great development
- the fundamental assumption that all action is driven by desire to maximise one´s wealth
