Intro to Accounting Theory

Question 1

What does accounting theory focus on?

Answer 1

Accounting theory focuses on people’s behaviour with respect to accounting information, the need for accounting information, and why particular information is supplied by organizations.

Question 2

What is the inductive method in accounting theory development?

Answer 2

The inductive method develops theories based on observation, as seen in early accounting theory development from the 1920s to 1960s.

Question 3

What is Positive Accounting Theory (PAT)?

Answer 3

PAT seeks to predict and explain why accountants choose particular accounting methods, based on the assumption of a rational economic person motivated by self-interest and wealth maximization.

Question 4

What are normative accounting theories?

Answer 4

Normative theories are based on what researchers believe should happen in certain situations, not necessarily based on observations.

Question 5

What are the classifications of normative theories?

Answer 5

Normative theories include true income theories (finding the ‘best’ measure of profits) and decision usefulness theories (determining information needs for specific users).

Question 6

What is the main criticism of positive theories of accounting?

Answer 6

Positive theories have been criticized for lacking prescription, neutrality claims implying a conservative bias, and ignoring the provision of practical advice.

Question 7

How did Positive Accounting Theory gain prominence?

Answer 7

PAT gained prominence in the 1960s due to the development of the Efficient Markets Hypothesis (EMH) and research, such as the Ball and Brown (1968) study on stock market reactions.

Question 8

What is agency theory in accounting?

Answer 8

Agency theory focuses on the relationship between principals (e.g., shareholders) and agents (e.g., managers), where agents may act in their own interest, leading to information asymmetries.

Question 9

What are the three types of agency costs?

Answer 9

• Monitoring costs: cost of monitoring agents.
• Bonding costs: cost involved in agents binding their behaviour to expectations of principals
• Residual loss: too costly to remove all opportunistic behaviour.

Question 10

What is the Bonus Plan Hypothesis?

Answer 10

Managers with bonus plans are more likely to use accounting methods that increase current income to maximize their bonuses.

Question 11

What is the Debt Hypothesis?

Answer 11

Firms with higher debt/equity ratios are more likely to use accounting methods that increase income to avoid debt covenant violations.

Question 12

What is the Political Cost Hypothesis?

Answer 12

Large firms are more likely to use accounting choices that reduce reported profits to minimize political scrutiny.

Question 13

What is the efficiency perspective in PAT?

Answer 13

The efficiency perspective explains how contracting mechanisms minimize agency costs through up-front arrangements that optimize firm performance.

Question 14

What is earnings management?

Answer 14

Earnings management is when managers use flexibility in accounting to maximize their utility or the firm’s market value, ranging from conservative accounting to fraudulent practices.

Question 15

What are some motivations for earnings management?

Answer 15

Motivations include capital market influences, contracting needs, regulatory requirements, tax implications, and changes in CEO.

Question 16

What are examples of earnings management techniques?

Answer 16

Techniques include aggressive revenue recognition, capitalizing operating costs, extending asset useful life, and manipulating reserves.

Question 17

What is the “good” and “bad” perspective of earnings management according to Scott (2003)?

Answer 17

Good earnings management is efficient contracting and conveys inside information; bad earnings management is opportunistic behaviour for short-term gains.

Question 18

What is the role of corporate governance in the context of earnings management?

Answer 18

Corporate governance structures, such as the board of directors and audit committees, are essential in regulating and monitoring earnings management.

Question 19

What is the Discretionary Accruals Model?

Answer 19

It analyses earnings management by examining how managers use estimates in the accounting system that have not yet been realized.

Question 20

What are examples of Discretionary Accruals Models?

Answer 20

The Healy Model, DeAngelo Model, and Jones Model—all used to test for the presence of earnings management.

Question 21

What is the opportunistic perspective in Positive Accounting Theory (PAT)?

Answer 21

It seeks to explain managers’ actions after contracts are in place, assuming managers opportunistically act to maximize their wealth due to incomplete contracts.

Question 22

What are the methods of rewarding managers?

Answer 22

Managers can be rewarded with either a fixed salary or a combination of salary and performance-based bonuses tied to metrics like profits, sales, or return on assets.

Question 23

What are some criticisms of Positive Accounting Theory (PAT)?

Answer 23

PAT is criticized for lacking prescription, oversimplifying human behaviour by assuming only self-interest, assuming market efficiency, and not fully explaining complex organizational relationships.