Deegan fat4e ppt_ch07

7-1Copyright © 2014 McGraw-Hill Education (Australia) Pty Ltd PPTs to accompany Deegan, Financial Accounting Theory 4e

FINANCIAL ACCOUNTING THEORYCraig Deegan

Slides written by Craig Deegan

CHAPTER 7Positive Accounting Theory


Learning objectives7.1 Understand how a positive theory differs from a normative

theory.

7.2 Be aware of the origins of Positive Accounting Theory (PAT).

7.3 Understand that PAT uses insights from agency theory and why agency theory is of relevance to financial accounting practices.

7.4 Be aware of the central assumptions of PAT.

7.5 Be aware of the meaning and nature of agency costs.

7.6 Understand why an organisation can usefully be referred to as a ‘nexus of contracts’.

7.7 Understand the perceived role of accounting in minimising the transaction costs of an organisation.

continued


Learning objectives (cont.)7.8 Be aware that accounting policy choices made by

management will be influenced by both efficiency considerations as well as opportunistic motivations.

7.9 Be able to identify the reasons for the existence of ‘creative accounting’.

7.10 Be able to explain the meaning of ‘political costs’ and how accounting can be used to reduce the costs associated with various political processes.

7.11 Understand the role of accounting-based management compensation schemes and debt covenants in reducing potential conflicts (agency costs) within an organisation.

7.12 Understand how particular accounting-based agreements with parties such as debtholders and managers can provide incentives for managers to manipulate accounting numbers. continued


Learning objectives (cont.)

7.13 Be aware of what constitutes ‘conservative’ accounting procedures and why conservative accounting procedures provide efficient mechanisms for minimising the contracting costs within an organisation.

7.14 Understand the relevance of PAT to current debates about how assets and liabilities should be measured.

7.15 Be able to identify some of the criticisms of PAT.


Positive theories compared to normative theories • A positive theory seeks to explain and predict

particular phenomena

– Positive Accounting Theory (PAT), which we explore in this lecture, is one example of a positive theory of accounting. Other examples are covered in the next lecture (when we consider theories such as Legitimacy Theory and institutional theories which are positive theories that can be applied to explain the practice of accounting)

• By contrast, normative theories (which were considered in Chapters 5 and 6) prescribe how a particular practice should be undertaken

– the prescription might depart from existing practice


Positive Accounting Theory defined

• PAT ‘… is concerned with explaining accounting practice. It is 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.’ (Watts and Zimmerman 1986, p. 7)

• Again, positive theories do not prescribe what should occur – they focus on explaining or predicting what does occur

continued


Positive Accounting Theory defined (cont.)

• PAT focuses on relationships between various individuals and explains how accounting is used to assist in the functioning of these relationships

• Examples of relationships

– between owners and managers

– between 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 extent that the actions will increase their wealth

– does not incorporate notions of loyalty or morality


Origins of PAT

• Started coming to prominence in mid-1960s

– paradigm shift from normative theories

• PAT became the dominant research paradigm in 1970s and 1980s

– shift resulted from US reports on business education, and improved computing facilities enabling large-scale statistical analysis – something common in positive research


Origins of PAT—capital markets research• Development of Efficient Markets Hypothesis (EMH)

by Fama and others provided an environment suitable for PAT research

– capital markets react in an efficient and unbiased manner to publicly available information

• Ball and Brown (1968) paper was crucial to the acceptance of the positive research paradigm

– investigated stock market reaction to accounting earnings announcements

– sought to explain market reactions continued


Origins of PAT—capital markets research (cont.)• Price of a security based on beliefs about present value of

future cash flows

• Ball and Brown found that earnings announcements impacted share prices

– evidence that historical cost information is useful to the market

• But the literature was unable to explain why particular accounting methods were selected – if the market was efficient as commonly assumed by researchers, and could understand how different accounting methods affect accounting numbers, then why does it matter what accounting method was selected? PAT addresses this issue


Firms and contracts• Firms can be characterised as a nexus of contracts

– between consumers of products and the suppliers of factors of production

• Firms exist because they reduce contracting costs,

– firms provide an efficient means of organising economic activity

– [consider the alternative, an individual organising the production of a good: acquiring the raw materials organising various people to make the good]

• Contracts include all types of agreements between two or more parties (not necessarily written contracts)


Origins of PAT—agency theory

• Agency theory was crucial to the development of PAT

• Agency theory explained why the selection of particular accounting methods might matter

• Focused on the relationships between principals and agents

– e.g. between shareholders (principals) and managers (agents)

• Information asymmetries create much uncertainty

– transaction costs and information costs exist


Agency relationship• The ‘agency relationship’ is a central focus of agency

theory

• Defined by Jensen and Meckling (1976)

– 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

• Agency theory key assumptions from the economics literature, such as:

– assumptions of self-interest and wealth maximisation


Price protection

• In the absence of contractual mechanisms to restrict agents’ potentially opportunistic behaviour, the principal will pay the agent a lower salary

– compensates principals for adverse actions

• Agents will therefore have incentives to enter contracts which appear to limit actions detrimental to agents


The agency problem

• At the core of the analysis 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 inefficiencies and information asymmetries

• The agency problem leads to ‘agency costs’


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


Role of accounting in contracts

• Accounting information is used to address the agency problem and to reduce agency costs

• Accounting is used as a monitoring and bonding mechanism to control the efforts of self-interested agents (managers)


Key hypotheses

• 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

• Research assumes managers will act opportunistically when selecting methods


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 organisation is exploiting other parties


Two perspectives adopted by PAT research

• Efficiency perspective

• Opportunistic perspective


Efficiency perspective

• Researchers explain how contracting mechanisms minimise agency costs of the firm

• Known as ex ante perspective

– mechanisms put in place up front to minimise future agency and contracting costs

• Managers select accounting methods which most efficiently reflect underlying firm performance

• PAT theorists argue that regulation forcing firms to use a particular accounting method imposes unwarranted costs and introduces inefficiencies


Opportunistic perspective• Seeks to explain managers’ actions once contracts

are already in place

• That is, particular accounting methods might initially be selected for efficiency reasons, but once they have been negotiated/agreed, then managers will aim to utilise accounting choices in a way that best serves their own interest

• Not possible to write complete contracts, so managers are assumed to opportunistically act to maximise own wealth

• Known as ex post perspective

– considers opportunistic actions after the fact


Owner/manager contracting• Assuming self-interest, owners expect managers

(agent) to undertake activities not always in the interest of owners (principal)

• Managers have access to information not always available to principals

– information asymmetry

– further increases managers’ ability to undertake activities beneficial to themselves

• Costs of divergent behaviour are agency costs continued


Owner/manager contracting (cont.)

• In the absence of controls to reduce opportunistic behaviour, agents (managers) expected to undertake activities disadvantageous to the value of the firm

• Principals price this into the amounts they are prepared to pay the manager

• Managers may contract themselves not to consume perks so will receive higher salary

– known as bonding


Methods of rewarding managers

• Fixed basis—salary independent of performance

– manager may not take great risks as does not share in potential gains

• Salary plus remuneration is, in part, tied to firm performance

– known as bonus schemes


Bonus schemes

• Remuneration can be tied to:

– profits of the firm

– sales of the firm

– return on assets

• All based on output from the accounting system

• May also be rewarded in line with market price of the firm’s shares


Accounting-based bonus plans• Any changes in accounting methods will affect the

bonuses paid

– may occur as a result of a new accounting standard in place

• Contracts in some circumstances may be based on the old method in place so changes will not affect bonuses

• Contracts relying on accounting numbers may rely on ‘floating’ GAAP


Incentives to manipulate accounting numbers• The decision to reward managers on the basis of

accounting profits might initially be introduced for efficiency reasons (it motivates them to work in a way that also benefits the principals), but it may subsequently induce them to manipulate accounting numbers (the opportunistic perspective)

– a change in accounting numbers will affect their rewards

• Bonuses based on profits cause short-term rather than long-term focus

– may affect investment in positive NPV projects if returns not expected to be consistent


Incentives to manipulate accounting numbers—evidence• Healy (1985) found:

– managers adopt accounting methods to maximise bonus if contract rewarded managers after a pre-specified level of earnings reached

– if income not expected to reach pre-specified minimum, managers shift earnings to future period (‘take a bath’)

• Lewellen, Loderer and Martin (1987) found:

– US managers approaching retirement are less likely to undertake R&D expenditure if rewards based on accounting-based performance measures

– short-term focus


Use of conservative accounting methods in management bonus schemes

• Conservative accounting methods, which would include historical cost, tends to delay the recognition of income, accelerate the recognition of expenses, and lead to lower asset and higher liability recognition

• Asset and income recognition based on assessments of fair value would not be considered a ‘conservative’ accounting approach

• Potential conflicts of interest between agents and principals are better managed when conservative accounting methods are used as they restrict the ability of managers to opportunistically use income and net asset increasing accounting methods


Market-based bonus schemes• Apart from accounting-based bonus schemes,

managers are also often provided with capital market-based bonuses

• May be more appropriate to remunerate managers in terms of market value of firm’s securities (shares) where accounting earnings fluctuate greatly

– e.g. mining, or high technology R&D firms

– or where managers are approaching retirement

• Methods include:

– cash bonus based on share price increases

– shares

– options to buy shares continued


Market-based bonus schemes (cont.)

• Providing managers with shares, or share options creates incentives for managers to increase the value of the firm – aligns their interests with those of the owners (principals)

• But, problems include:

– share price also affected by factors beyond the control of managers (e.g. general market movements)

– only senior managers likely to have a significant impact on share value

continued


Market-based bonus schemes (cont.)• But remember, regardless of how managers are rewarded there is

always a maintained assumption within PAT that managers (and everybody else) will be opportunistic

• Consider results of Bartov and Mohanram (2004):– In presence of deteriorating profitability managers are likely to adopt

income increasing accounting methods to increase share prices and therefore the value of their share options. They would then exercise their share options thereby acquiring the shares, and fairly quickly sell the shares before reported profits ultimately decline and the value of the shares fall

• Aboody and Kasnik (2000):– if managers know that share options were to be granted to them they will

disclose ‘bad news’ so as to reduce share prices and therefore the likely future exercise price of the share options. This would mean that when they ultimately exercise the granted options, thereby buying the underlying shares, they will pay less and therefore make greater financial gain


Choice of accounting versus market-based bonus schemes

• Managers’ bonuses are more likely to be based on accounting earnings where:

– share returns relatively more sensitive to general market movements

– earnings have a high association with firm-specific movement in the firm’s share values

– earnings have a less positive association with market-wide movements in equity values


Debt contracting—agency costs of debt• Moving our attention to the relationship with

debtholders, in the absence of safeguards to protect debtholders (creditors), managers are predicted to adopt strategies to disadvantage the debtholders

• Agency costs of debt created by managers include

– excessive dividend payments, which leave fewer assets to service debt

– the organisation may take on additional debt, with new debtholders competing with original debtholders for repayment (claim dilution)

– investment in high-risk projects may not be beneficial to debt holders as they have a fixed claim (asset substitution)

– underinvestment


Use of debt contracts• In the absence of safeguards to protect the interests

of debtholders from strategies such as those on the previous slide, it is assumed the debtholders will require the firm to pay higher costs of interest to compensate for the risks

• That is, they will ‘price protect’

• If firms contract not to pay excess dividends, take on high levels of debt, invest in risky projects, or under-invest then they can attract debt at lower cost

• Hence, it is efficient to enter into contracts that restrict the ability of managers to adversely affect the wealth of debtholders


Evidence from Australian debt contracts

• In relation to Australian debt contracts, Cotter (1998) found:

– leverage covenants frequently used in bank loan contracts

– leverage most frequently measured as the ratio of total liabilities to total tangible assets

– prior charges covenants typically included in term loan agreements of larger firms

– prior charges covenants defined as a percentage of total tangible assets

continued


Australian debt contracts (cont.)

– debt to assets, interest coverage and current ratio clauses frequently in use

– interest coverage required to be between 1½ and 4 times

– current ratio clauses required current assets be between 1 and 2 times the size of current liabilities

continued


Australian debt contracts (cont.)

• Mather and Peirson (2006) provide evidence of a change in the use of covenants relative to earlier periods. Their findings include:

– a reduction in the use of debt/asset restrictions;

– greater variety of debt convents being used;

– more common covenants include minimum interest coverage; minimum dividend coverage; minimum current ratio; minimum required net worth;

– use of ‘rolling GAAP’ more common – which introduces risks for the borrower;

– mean number of covenants in public debt contracts less than private debt contracts – explained from an efficiency perspective


The role of conservative accounting methods in reducing the agency costs of debt

• As with management bonus schemes, it is believed that the use of conservative accounting methods are relatively more effective in reducing agency costs of debt

• Zhang (2008) suggests that from an efficiency perspective, managers might agree to adopt conservative accounting methods because it allows them to attract debt at a lower price

• The use of conservative accounting procedures means that debt covenants restricting the amount of debt relative to assets (or debt to equity), or the amount of times profits must cover interest (known as an ‘interest coverage’ clause), will tend to be more restrictive or binding compared to those organisations that do not adopt conservative accounting methods.

continued


The role of conservative accounting methods in reducing the agency costs of debt (cont)

• As Zhang (2008) argues, the more binding covenants will provide an earlier warning of default risk, and will thereby reduce the risk exposure of the lending party (for example, a bank)

• The reason for this is that, because management will have less ability to circumvent restrictive covenants (for example, by undertaking asset revaluations), such covenants will create a technical default of a loan agreement earlier than if management has the scope to loosen the restrictions

• The earlier the lender can take action to safeguard its funds, the lower the risk to the lender


Debt contracts—manager’s incentive to manipulate• Ex post, the incentive to manipulate accounting numbers

increases as the accounting-based debt covenants approach violation

• Managers found to manipulate accounting accruals in the years before and the year after violation of a debt agreement

• Too costly to stipulate all acceptable accounting methods in contract so managers always have some discretionary ability

• But as we have learned, contracts that require the use of conservative accounting methods reduce the ability of managers to opportunistically manipulate accounting numbers


Role of external auditors

• Auditors arbitrate on the reasonableness of the accounting method chosen

• Demand for financial statement auditing when:

– management is rewarded on the basis of numbers generated by the accounting system

– the firm has borrowed funds, and accounting-based covenants are in place to protect the investment of debtholders


Political costs• We have already indicated that financial accounting

numbers are important with respect to debt contracting and management compensation contracting. Financial accounting also plays a key role in the political process

• Political costs are costs resulting from political attention from government, lobby groups etc.

• Commonly directed at larger firms

– indication of market power

• May result in increased taxes, increased wage claims, product boycotts etc.

• Firms likely to adopt accounting methods to reduce profits to lower political scrutiny


Political actions of individuals• Limited expected ‘pay-off’ results from the actions of

individuals

• Results in formation of interest groups

• Information costs shared, ability to investigate government and business action increases

• Given self-interest, representatives of interest groups predicted to maximise own welfare as constituents have limited motivation or means to be fully informed


Actions of politicians• Politicians know that highly profitable companies

could be unpopular with members of their constituency

• Politicians (who are assumed to be driven by self-interest like everybody else) could win votes by taking actions against the companies

– argue that it is in public interest even though in own interest

• May rely on reported profits to justify actions

– provides incentives for firms to reduce reported profits


Example of how politicians use accounting numbers as a means of justifying actions against an organisation• As reported in the Hobart Mercury on 9 March 2013, the Australian

Greens political party used the size of bank assets and profits as the basis for levying additional taxes on banks. The article stated:

The Greens want a levy of 0.2 per cent on all bank assets above $100 billion in return for Federal Government guarantees, which the independent Parliamentary Budget Office has costed as raising $11 billion over the next four years.

“At a time when there's pressures on the budget, and the government is looking around for ways of raising revenue, especially in light of the failed mining tax, who can afford to pay it the most?" Australian Greens’ Mr Bandt said yesterday.

"If we don't stand up to the big banks and the big miners, then the Labor Party is going to come after the rest of us, like they have with single parents, and like they are threatening with the forthcoming budget."

• As we can see, ‘profits’ are used to justify the proposed action. Lower reported profits would provide less ‘ammunition’ for the politicians


Relevance of PAT-based research to current efforts of IASB to promote use of fair values• As already indicated in this lecture, conservative

accounting methods lead to:– relatively lower revenue recognition

– faster expense recognition

– higher liability recognition

– lower asset recognition

• Historical cost accounting is a conservative approach to accounting when compared to fair value accounting

• Conservative accounting methods, such as historical costs, reduce the ability of managers to manipulate accounting numbers compared to fair value accounting

continued


Relevance of PAT-based research to current efforts of IASB to promote use of fair values (cont)

• Do the ongoing efforts of the IASB to embrace fair values make sense from an efficient contracting perspective?

• Because conservative accounting methods reduce the possibility that management will undertake opportunistic earnings management, organisations that use conservative accounting methods might be able to attract debt and equity capital at a lower cost because of perceptions about lower risk

• Applying this reasoning, numerous researchers argue that the IASB and FASB should take note of the advantages inherent in conservative accounting procedures before finalising any judgements about accounting measurement continued


Relevance of PAT-based research to current efforts of IASB to promote the use of fair values (cont)

• Whilst information about fair values will be useful to various financial stakeholders in terms of assisting them to make informed investment/resource allocation decisions, more conservative accounting methods also provide benefits in terms of controlling potentially divergent behaviour of individuals involved in various contractual arrangements.

• There is a clear-trade-off between the advantages of having relevant information about current values and the contracting benefits that more conservative accounting benefits provide


Criticisms of PAT

• Does not provide prescription

• PAT is not value-free as it asserts assumption that all action is driven by self-interest

• Argued to be too negative and simplistic a perspective of humankind

• Issues have not shown great development

• In undertaking large-scale empirical research, researchers ignore organisational-specific relationships


Diagrammatic summary of PAT