L4 Introduction to positive accounting theory and agency theory Flashcards
What is a positive theory?
A positive theory describes, explains, or predicts real-world behavior without prescribing what should happen. It focuses on what is, not what ought to be.
What does Positive Accounting Theory (PAT) aim to do?
PAT aims to describe, explain, and predict actual accounting practices used by firms.
Is PAT normative or empirical?
PAT is empirical — it is based on observing real-world data and behavior.
Whose economic work does PAT draw on for its methodology?
Milton Friedman (1953), who emphasized that theories should be judged by their ability to predict, not by the realism of their assumptions.
What does ‘methodology’ mean in the context of PAT?
It refers to the rules used by a science to accept or reject theories and hypotheses.
What is the key difference between Positive and Normative accounting theories?
Normative theories focus on finding the best way to account for transactions based on certain assumptions. The subject is accounting itself.
Positive theories aim to explain or predict the behavior of stakeholders (e.g., accountants, shareholders, creditors) who make or use accounting decisions. The subject is the people involved in accounting.
What is the focus of PAT?
Focuses on relationships between various individuals (sometimes represented empirically by ‘markets’) and how accounting affects these relationships.
Examples of key relationships:
- Owners (shareholders) and managers
- Managers (or the firm) and the firm’s debt providers
- Managers (or the firm) and regulatory bodies
What are the assumptions underlying PAT?
- Individuals’ action is driven by self-interest and individuals may act in an opportunistic manner to the extent that the actions will increase their wealth
- People are aware of the self-motivation of others and expect other people to behave selfishly
- This does not necessarily mean that individuals always act opportunistically, simply that the possibility of this occurring cannot be excluded.
What are the two fields of research in PAT?
- Response of users to financial reporting
- Factors affecting decisions made by the firm or those within the firm.
What did Jensen and Meckling (1976) find about manager ownership and incentives?
The greater the manager’s ownership in the firm, the stronger their incentive to act in the firm’s interest.
Why does a 100% owner-manager have strong incentives to act in the firm’s interest?
Because they receive 100% of both the benefits and the costs of their efforts.
What is the consequence of a manager owning only 50% of a firm, according to J&M?
The manager bears only 50% of the cost of shirking but gets 100% of the benefit of slacking off.
How does partial ownership influence spending behavior, according to J&M?
A partially owning manager is more likely to overspend on personal perks (e.g., an expensive desk lamp) since they don’t bear the full cost.
What is Moral Hazard in agency relationships?
Moral hazard occurs when the agent takes actions that harm the principal because the principal cannot perfectly observe the agent’s behavior.
Example: An insured restaurant owner might burn down their own restaurant to collect insurance money.
What is Adverse Selection in agency relationships?
Adverse selection occurs when the agent takes actions that harm the principal because the principal cannot observe all of the agent’s potential courses of action perfectly.
Example: A manager may select projects she prefers and hide the other available choices from the board/shareholders.
What is the impact of lower managerial ownership on the firm and shareholders?
When managers own less of the firm, their effort decreases, leading external shareholders to expect lower returns. This increases the cost of capital (higher cost of equity). To address this, firms engage in monitoring and bonding activities (like incentives) to align managers’ interests with shareholders.
What is monitoring in the context of agency relationships?
Monitoring refers to the mechanisms by which the performance of managers (agents) is observed and controlled by shareholders (principals). This includes corporate governance systems, such as internal mechanisms (board of directors) and external mechanisms (government regulations, takeovers, labor market for managers). Corporate governance became a key focus after major company collapses in the early 2000s.
What is bonding in the context of agency relationships?
Bonding describes the mechanisms implemented to try to directly align the interests of the agent and principal
- incentive contracts
- bonus schemes
- Employee option schemes
What are the 3 direct incentives provided to managers so they undertake projects that enhance shareholder wealth?
- Bonus schemes
- Giving managers shares in the company
- Giving managers call options on shares
What is the problem with giving managers only ordinary shares as incentives?
Giving managers ordinary shares may lead them to avoid risky but beneficial projects because they are overly concerned with unsystematic risk. Shareholders can diversify this risk, but managers can’t. This may result in managers not pursuing projects that increase shareholder wealth, and the board may never know about these missed opportunities.
How can ESOs create new agency costs?
Managers may influence the number and terms of options granted or control information given to the board, leading to decisions that benefit them but not shareholders.
Why do firms give managers call options instead of just ordinary shares?
Call options avoid downside risk for managers while still encouraging them to increase share prices. This aligns their interests with shareholders without making them overly cautious about company-specific risks.
What are 4 incentive alignment issues regarding shareholder-manager relationships?
- Excessive Dividend Retention
- Horizon Problems
- Excessive Risk Aversion
- Compensation Package induced effects
What is Excessive Dividend Retention and why is it a problem in shareholder–manager relationships?
Managers may retain earnings instead of paying dividends, even when no positive-NPV projects exist. This can happen because they want to:
- Empire build (grow the company to boost personal status), or
- Reduce downside risk (keep a financial cushion since they can’t diversify their risk like shareholders).
This misaligns managerial incentives with shareholder interests.
What is the Horizon Problem in shareholder–manager relationships?
Managers nearing retirement may avoid long-term, positive-NPV projects because:
- They won’t be around to see the payoff
- Their rewards are based on short-term performance
This misaligns their goals with shareholders who prefer long-term value creation.
What is the Efficient Market Hypothesis (EMH) and how does it relate to the Horizon Problem?
The Efficient Market Hypothesis (EMH) suggests that all available information is immediately reflected in share prices.
- If EMH holds, long-term projects with positive-NPV should be rewarded by the market immediately, so managers could still look good in the short term.
- However, in reality, market imperfections make it hard for managers to gain credit for long-term value before they retire.
What is the Shareholder-Debtholder Agency Problem?
The shareholder-debtholder agency problem arises because debt-holders lend money to the firm but have limited control over how the funds are used, and may bear the downside risk if the firm fails.
What is the incentive problem caused by limited liability for borrowers?
Limited liability creates an incentive for borrowers to take high-risk projects because they can keep the profits if the project succeeds, but the creditor bears the loss if it fails.
How do loan covenants help mitigate the agency problem between shareholders and debt-holders?
Loan covenants restrict the borrower’s behavior, such as limiting future borrowing and setting debt-to-equity ratios to prevent excessive risk-taking.
Why are loan covenants monitored regularly?
Loan covenants are monitored to ensure that the borrower complies with restrictions on risk-taking behavior, protecting the creditor’s interests.
What are common covenants in Australian debt contracts?
Common covenants include leverage ratios (debt-to-assets), interest coverage ratios, and current ratios to limit excessive borrowing and ensure the borrower can meet interest payments.
What is the role of external auditors in financial reporting?
External auditors attest to the truth and fairness of financial reports, giving an opinion on the accuracy of the reports generated by the accounting process.
Demand for auditing increases when:
- Management is rewarded based on accounting figures.
- The firm has borrowed funds with accounting-based covenants.
All large proprietary and public companies must appoint an external auditor.
What are the 4 criticisms of PAT?
No Prescriptions: PAT explains behavior but doesn’t suggest what should be done.
Not Truly Value-Free: Research choices and assumptions may reflect researcher values.
Self-Interest Assumption: Criticized as too negative; PAT just assumes others might act selfishly.
Ignores Specifics: Large-scale studies may overlook unique firm-level relationships.
What are the two types of decision rights in an organisation?
Decision management rights (initiation, implementation) - Managers often hold decision management rights
Decision control rights (ratification, monitoring) - but important decisions are subject to ratification by those who hold decision control rights (the Board)
