Positive Accounting Theory Flashcards
What are the assumptions of PAT?
- Actions driven by self-interest; individuals act to maximise wealth
- Excludes considerations of loyalty or morality in the decision-making process.
PAT
Focuses on relationships among individuals and accounting’s role (owners, managers, debt providers).
Research aimed at explaining and predicting accounting practices rather than prescribing particular practices.
Why would a manager not work as hard as the owner
When decision-making authority is delegated, this can lead to some loss of efficiency and consequent potential loss (known as agency cost).
For example, a manager may not share a direct stake in the organisation’s results.
What are the consequences of a manager preparing a financial statement?
To avoid agency costs, managers may receive a share of organizational profits. However, it is anticipated that managers are motivated to offer information that accurately reflect the entity’s performance, incurring bonding costs.
If managers are predicted to prepapre a FS, then PAT would suggest a need for audits or monitoring (involving monitoring costs). Otherwise managers, motivated by self-interest, might attempt to inflate profits to boost their share of earnings.
What is normative theory?
…outlines how accounting should be done, offering guidelines and standards.
In contrast to PAT, which observes actual accounting practices, normative theory prescribes the “right” way to conduct accounting, emphasising principles and ethical considerations for fairness, transparency, and accuracy in financial reporting.
Role of efficient market hypothesis
An aspect that reinforces the dominance of PAT is its alignment with EMH.
Based on the assumption that capital markets react in an efficient and unbiased manner to the publicly available information.
If EMH holds true, managers believe that markets quickly reflect information, they may avoid opportunistic practices in financial reporting, as it could be detected othewrise.
What did Ball and Brown research found
A pivotal moment in PAT recognition was marked by Ball and Brown’s research.
Their empirical findings demonstrated that earnings announcements, mainly based on historical cost accounting, influenced share prices.
This suggests that if managers perceive historical cost accounting as positively affecting share prices, they may choose to present information in that manner to maximise their wealth.
what would owners do to avoid agency costs?
PRICE PROTECTION
Owners may restrict manager’s potential opportunistic behaviour by paying the them a lower salary, which compensate the owners for the adverse actions that the managers may undertake
Incentive is reduced but not eliminated.
Why would managers work to the benefit of their owners.
Owners may offer lower wages, with expectation that employees will work harder to generate higher earnings.
Even in the absence of regulatory requirements, managers are motivated to offer information that accurately reflect the entity’s performance. Otherwise, it can harm their reputation and impacting the income potential from the organisation.
Why do larger firms tend to support the Discussion Memorandum
- During inflation, firm profits were understated.
- Lower reported profits aimed to avoid political attention and prevent wealth transfer (higher wages, increased taxes).
- Higher debt/equity ratios increase the likelihood of managers using income-increasing accounting methods to lower technical default costs.
Criticism of PAT
- Fails to offer prescriptions, limiting its contribution to enhancing the quality and fairness of accounting standards.
- Perceived as oversimplification or cynicism of the self-interest assumption.
- Assumption of market efficiency, which may not always align with real-world complexities.
- Issues have not shown great development.
- In undertaking large-scale empirical research, researchers ignore organisational-specific relationships
Criticism of Normative Theories
Lack of empirical observation (which then lack relevance)
Based on personal opinion about what should happen
- Limiting their acceptance in diverse business context
The three hypothesis
Bonus plan hypothesis
Debt hypothesis
Political cost hypothesis
Why do owners expect managers to undertake activities not always in the interest of owners
managers have access to information not always available to owners (information asymmetry)
which further increases managers ability to undertake activities beneficial to themselves
