Positive Accounting Theory Flashcards

1
Q

Definition

A
  • 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 a firm should use
  • Focuses on relationships between various individuals and how accounting is used to assist in the functioning of these relationships
  • Example of relationships: owners and managers, managers and the firm’s debt providers
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2
Q

Assumptions underlying PAT

A

All individuals’ action is driven by self-interest and individuals will act in an opportunistic manner to the extend that the actions will increase their wealth

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3
Q

Origins of PAT

A
  • Started coming to prominence in mid 1960s, paradigm shift from normative theories
  • Dominant research paradigm in 1970s and 1980s, shift resulted from US reports on business education and improved computing facilities enabling large-scale statistical analysis
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4
Q

Origins of PAT - Agency theory

A
  • Explained why the selection of particular accounting methods might matter
  • Focused on the relationships between prinicpals and agents
  • Information asymmetries create much uncertainty
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5
Q

Agency costs

A

Monitoring costs
- costs of monitoring agents behaviour
- e.g. auditing financial statements
Bonding costs
- costs involved in agents bonding their behaviour to expectations of principals
- e.g. preparing financial statements
Residual loss
- too costly to remove all opportunistic behaviour

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6
Q

Key hypotheses

A

Frequently used in PAT literature to explain and predict support or opposition to an accounting method:
- Bonus plan hypothesis
- Debt hypothesis
- Political cost hypothesis

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7
Q

Bonus plan hypothesis

A

Managers of firms with bonus plans are more likely to use accounting methods that increase current period reported income.
- also called management compensation hypothesis
- action increases the present value of bonuses paid to management

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8
Q

Debt hypothesis

A

The higher the firm’s debt/equity ratio, the more likely managers use accounting methods that increase income
- also called debt/equity hypothesis
- the higher the debt/equity ratio, the closer the firm is to the constraints in debt covenants
- covenant violation results in costs of technical default

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9
Q

Political cost hypothesis

A

Large firms rather than small firms are more likely to use accounting choices that reduce reported profits
- size is a proxy variable for political attention
- reduction of reported income is hypothesised to reduce the possibility that people will argue that the organization is exploiting other parties

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10
Q

Culture of forming and testing hypotheses

A
  • In the 1960s, there was a change in how research was done.
  • People started to focus more on creating and testing ideas in a systematic way.
  • This scientific approach, which is linked to a positive and practical philosophy, became a key feature of high-quality research.
  • In different fields, including accounting, researchers began to use a more organized and hypothesis-driven method to study things.
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11
Q

Technological advances - computers and databases

A
  • In the 1960s, the introduction of computers and big electronic databases changed how researchers could study things using real-world data.
  • Thanks to this technology, scholars could now quickly analyze a large amount of financial information.
  • Important databases like the Center for Research in Security Prices (CRSP) and Compustat gave researchers access to huge sets of data, playing a crucial role in their studies on practical accounting matters.
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12
Q

Lowered cost of empirical work

A

The use of computers and electronic databases significantly lowered the cost of empirical research

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13
Q

Positive economic and finance theories

A
  • In response to the lowered cost of empirical work, positive economic and finance theories became more accessible for accounting reasearchers.
  • Economic theories, particulary agency theory and information economics, provided a framework for understanding the economic motivations behind the accounting decisions.
  • This availability of theoretical foundations facilitated the development of PAT.
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14
Q

Impact on accounting research

A
  • Replacement of normative accounting theory
  • Support of semi-strong efficient market hypothesis (EMH)
  • Impact on informational content understanding of financial statements
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15
Q

Replacement of normative accounting theory

A
  • PAT marked a significant shift from normative accounting theories.
  • Normative theories such as those based on ethical principles or idealistic assumptions about how accounting should be practiced, were challenged by PAT’s empirical and positive approach.
  • PAT emphasized explaining and predicting actual accounting practices based on economic motivations, contrasting with normative theories that prescribed how accounting should ideally function.
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16
Q

Support of semi-strong efficient market hypothesis (EMH)

A
  • PAT aligns with the idea of semi-strong efficient market hypothesis (EMH).
  • The semi-strong EMH assumes that all publicly available information is reflected in asset prices, making it difficult for investors to constantly achieve above-average returns based on historical or publicly known information.
  • PAT, by emphasizing the role of accounting information in reducing information asymmetry, supports the notion that prices in semi-strong efficient markets incorporate relevant and publicly available information.
17
Q

Impact on informational content understanding of financial statements

A
  • PAT has deepened our understanding of the informational content of financial statements.
  • The theory suggests that accounting choices are made to convey specific information to different stakeholders, particularly investors.
  • As a result, researchers and practitioners have examined the content of financial statements more critically, considering not only reported numbers but also the economic incentives behind them.