Week 6 Positive Accounting Theory Flashcards
What is positive accounting theory concerned with?
Concerned with explaining and predicting which firms will and which firms will not use a particular method but it says nothing as to which method a firm should use.
What does agency theory explain?
Explains why the selection of particular accounting methods might matter?
What is the agency relationship?
A contract under which one or more (principals) engage another person (the agent) to perform some service on their behalf which involves delegating some decision-making authority to the agent.
What assumptions does agency relationship make?
Assumptions of self-interest and wealth maximisation.
How are incentive problems controlled?
Through contracts
What is the primary factor that limits the ability of contracts to solve incentive conflicts?
Costly information
Why is information likely to be asymmetrical?
The manager knows more than the owners about the profit potential of the firm and his perquisite taking.
What is price protection?
In the absence of contracts to restrict agents’ potentially opportunistic behaviour the principal will pay the agent a lower salary to compensates principals for adverse actions of the agent.
Well designed contracts ALIGN the interests of managers with what?
LONG-TERM firm value
What is the agency problem?
The agency problem relates to issues associated with motivating one party (the agent) to work in the best interests of another party (the principal).
Agency problems arise because of what?
Inefficiencies and information asymmetries
The agency problem leads to what?
Agency costs
What are the three types of agency costs?
Monitoring costs
Bonding costs
Residual costs
What are monitoring costs?
Costs of monitoring agents’ behaviour.
What are bonding costs?
Costs involved in agents bonding their behaviour to expectations of principals.
What is residual costs?
The loss from not being able to remove all opportunistic behaviour due to that being too costly.
What are three 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
What is earnings management ?
Earnings management uses accounting methods that ensure that the profit and loss statement presents the preparer’s desired level of reported profit/loss.
What are the three techniques that firms may use to manage their reported earnings.
Manipulate accruals
Timing of transactions
Change accounting policies
How is manipulating accruals used to manage a firm’s reported earnings?
Shifting revenues and expense between periods.
How is the timing of transaction used to manage a firm’s reported earnings?
By delaying or accelerating asset sales.
How is changing accounting policies used to manage a firm’s reported earnings?
By being an early adopter of a new standard that increases income.
What is the bonus plan hypothesis / management compensation hypothesis?
Managers of firms with bonus plans are more likely to use accounting methods that increase current period reported income.
What is the debt (debt/equity hypothesis) hypothesis.
The higher the firm’s debt/equity (or debt/assets) ratio, the more likely managers use accounting methods that increase income (or assets).
The higher the debt/equity ratio (or debt/assets), the closer the firm is to what?
Constraints in debt covenants.
What is a debt covenant violation?
A breach of contract.
What are political costs?
Political costs are costs resulting from political attention from government, lobby groups etc.
Political costs may result in what?
Increased taxes, increased wage claims, product boycotts etc.
What are the two perspectives adopted by PAT research?
Efficiency perspective
Opportunistic perspective
What is the efficiency perspective concerned with?
Concerned with the efficiency of contracts based on estimates.
Under the efficiency perspective, managers/preparers will select accounting methods based on what?
Economic performance
What is the opportunistic perspective concerned with?
Recognises contracts are never complete so concerned with managerial avoidance beforehand.
Under the opportunistic perspective, managers/preparers will select accounting methods based on what?
What suits their own purposes and manage earnings.
Assuming self-interest, owners expect managers (agent) to undertake activities not always in the interest of who?
Owners (principal)
Managers have access to information not always available to who?
Principals
Costs of divergent behaviour are what type of cost?
Agency costs
In the absence of controls to reduce opportunistic behaviour, agents (managers) expected to undertake activities disadvantageous to who?
The value of the firm
When managers contract themselves not to consume perks so will receive higher salary, this is known as what?
Bonding
What is the fixed basis of rewarding managers?
Salary independent of performance.
Under the fixed basis of rewarding managers, why might manager not take great risks?
Because they do not share in potential gains.
What is the salary plus remuneration basis of rewarding managers?
Base salary with bonuses tied to performance.
What is an example of market-based bonus schemes?
Shares (incentive to help the company)
In the absence of safeguards to protect debtholders (creditors), managers are predicted to adopt strategies to do what?
Disadvantage the debtholders
Conservative accounting methods lead to what?
Relatively lower revenue recognition
Faster expense recognition
Higher liability recognition
Lower asset recognition
