Chapter 8

Question 1

Positive accounting theories - definition

Answer 1

Theories that seeks to explain and predict particular phenomena ( contrast to normative theories which prescribe how a particular practice should be undertaken)

Question 2

Positive Accounting Theory (PAT) - definition

Answer 2

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

Question 3

Assumptions underlying PAT

Answer 3

• 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)

Question 4

Origins of PAT - start

Answer 4

Became the dominat research paradigm in 1970s and 1980s because of improved computing facilities enabling large-scale statistical analysis (positive research)

Question 5

Origins of PAT - EMH

Answer 5

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

Question 6

Origins of PAT - Agency Theory

Answer 6

Crucial to the development of PAT.
Explained why the selection of particular accounting methods matter, focused on the relationship between principals and agents.

Question 7

Information asymmetries

Answer 7

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

Question 8

Agency relationship

Answer 8

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

Question 9

Key assumptions agency theory

Answer 9

• self-interest
• wealth maximisation

Question 10

The agency problem

Answer 10

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.

Question 11

The different agency costs

Answer 11

• 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

Question 12

3 key hypotheses frequently used in PAT literature to explain, and predict support oropposition to, an accounting method (Watts & Zimmerman):

Answer 12

• Bonus plan hypothesis
• Debt hypothesis
• Political cost hypothesis

Question 13

Bonus plan hypothesis

Answer 13

Managers with bonus plans (tied to reported income) are more likely to use accounting methods that increase current period reported income

Question 14

Debt hypothesis

Answer 14

Proposes that organisations close to breaching accounting-based debt covenants will select accounting methods that lead to an increase in profits and assets

Question 15

Political cost hypothesis

Answer 15

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)

Question 16

2 Perspectives adopted by PAT research

Answer 16

• 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)

Question 17

Bonus schemes

Answer 17

A method of rewarding managers where remuneration can be tied to:
- profits
- sales
- return on assets

Question 18

Earnings management - definition

Answer 18

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

Question 19

“Accrual-based earnings management”

Answer 19

Earnings management can be undertaken as a result of making various discrentionary accruals of income or expenses

Question 20

“Real earnings management”

Answer 20

Earnings management can be come about as a result of selectively undertaking actual transactions near the end of the financial year

Question 21

Some criticisms to positive accounting theory

Answer 21

• does not provide prescription
• have not shown great development
• the fundamental assumption that all action is driven by desire to maximise one´s wealth