Positive Accounting Theory Flashcards
Definition
- 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
Assumptions underlying PAT
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
Origins of PAT
- 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
Origins of PAT - Agency theory
- Explained why the selection of particular accounting methods might matter
- Focused on the relationships between prinicpals and agents
- Information asymmetries create much uncertainty
Agency costs
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
Key hypotheses
Frequently used in PAT literature to explain and predict support or opposition to an accounting method:
- Bonus plan hypothesis
- Debt hypothesis
- Political cost hypothesis
Bonus plan hypothesis
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
Debt hypothesis
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
Political cost hypothesis
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
Culture of forming and testing hypotheses
- 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.
Technological advances - computers and databases
- 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.
Lowered cost of empirical work
The use of computers and electronic databases significantly lowered the cost of empirical research
Positive economic and finance theories
- 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.
Impact on accounting research
- Replacement of normative accounting theory
- Support of semi-strong efficient market hypothesis (EMH)
- Impact on informational content understanding of financial statements
Replacement of normative accounting theory
- 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.
