l10 : positive accounting theory Flashcards
explain positive accounting theory.
designed to explain and predict which firms will and will not use a particular method, but does not dictate which method a firm SHOULD use.
focuses on rs between individuals and how accounting is used to assist functioning of these rs. eg. owners & managers, managers & debt providers
what is the weakness of using PAT to explain and predict accounting methods?
does not consider notions of loyalty or morality. all individuals actions are driven by self interest, meaning opportunistic behaviour to increase their wealth.
what is the origins of PAT according to agency theory?
explained why selection of particular accounting methods might matter. focused on rs between principal & agents. info asymmetries create uncertainty.
what is price protection?
principal will pay agent (director) a lower salary to compensate for “adverse actions”. agents therefore have incentive to enter contracts which appear to limit actions detrimental to themselves. leads to pay and incentive problems
state and explain the three types of agency costs.
monitoring costs (costs of monitoring agents behaviour eg. auditing financial statements)
bonding costs (costs involved in agents that commit or bond their behaviour to expectations of principals)
residual loss (too costly to remove all opportunistic behaviour)
what is the bonus plan hypothesis?
managers with bonus plans more likely to choose accting policies that shift reported earnings from future periods to current period.
increases current period reported income, increases present value of bonuses paid to them
what are three predictions on managers behaviour using bonus plan hypothesis?
- will choose less conservative & volatile accting policies
- oppose new accting standards that reduce net income
- object to volatility-increasing accting standards (fair value accting)
what is the debt hypothesis?
higher the firms debt-to-equity ratio, more likely to use methods that increase income. closer the firm is to their debt covenants (conditions), more likely that manager will increase current income to reduce risk of technical default. may increase variability of earnings, so mgt dislike.
what are two predictions on managers behaviour using debt hypothesis?
- choose less conservative accting policies
- oppose new standards which restrict ability to increase current income
what is the political cost hypothesis?
greater the political costs faced, more likely to defer reported earnings from current to future periods. likely in large firms who dont want to report high profits eg. due to media scrutiny, windfall taxes, investigation into competition in market
what are two predictions on managers behaviour using political cost hypothesis?
- choose more conservative accting policies
- less likely to oppose income-reducing accting standards
what are the two types of earnings management methods?
DACC (discretionary accruals), whereby accounting choices made on depreciation, inventory valuation, impairments, R&D
RM (real earnings management), whereby economic choices made on discretionary spending like research, advertising & choice of disposal date
what are the three motives for earnings management according to PAT?
- contractual terms (exec pay contracts - bonus hypo, debt covenants - debt hypo)
- political cost (avoid high profile earnings)
- capital markets (overvalued companies, IPO, earnings game)
why is overvalued companies a motive for EM?
markets not rational, so mgt believe market can be misled if EM done. longer the firm is overvalued, greater the total EM.
capitalises on irrationality of markets for investors to not realise overvaluation.
