Financial Accounting Theory
Craig Deegan
Chapter 7
Positive accounting theory
Slides written by Craig Deegan and Michaela
Rankin
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Learning objectives
• In this chapter you will be introduced to
– how a positive theory differs from a normative theory
– the origins of Positive Accounting Theory (PAT)
– the perceived role of accounting in minimising the
transaction costs of an organisation
– how accounting can be used to reduce the costs
associated with various political processes
– how particular accounting-based agreements with parties
such as debtholders and managers can provide
incentives for managers to manipulate accounting
numbers
– some criticisms of PAT
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Positive compared to normative theories
• A positive theory seeks to explain and predict
particular phenomena
• Normative theories prescribe how a particular
practice should be undertaken
– the prescription might depart from existing practice
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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)
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Positive accounting theory defined (cont.)
• Focuses on relationships between various
individuals and how accounting is used to assist in
the functioning of these relationships
• Examples of relationships
– owners and managers
– managers and the firm’s debt providers
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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
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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
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Origins of PAT—capital markets research
• Development of Efficient Markets Hypothesis
(EMH) by Fama and others
– 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
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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
• Literature unable to explain why particular
accounting methods selected
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Origins of PAT—Agency theory
• Explained why the selection of particular
accounting methods might matter
• Focused on the relationships between principals
and agents
– e.g. shareholders and managers
• Information asymmetries create much uncertainty
– transaction costs and information costs exist
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Agency relationship
• 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 decisionmaking authority to the agent’
• Relies on traditional economics literature
– assumptions of self-interest and wealth maximisation
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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
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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
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Role of accounting in contracts
• Accounting information used to reduce agency
costs
• Used as monitoring and bonding mechanisms to
control the efforts of self-interested agents
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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
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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
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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
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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
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Two perspectives adopted by PAT
research
• Efficiency perspective
• Opportunistic perspective
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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
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Opportunistic perspective
• Seeks to explain managers’ actions once contracts
are already in place
• 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
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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
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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
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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
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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
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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
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Incentives to manipulate accounting
numbers
• Rewarding managers on the basis of accounting
profits may induce them to manipulate accounting
numbers (the opportunistic perspective)
– 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
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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
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Market-based bonus schemes
• May be more appropriate to remunerate managers
in terms of market value where accounting
earnings fluctuate greatly
– e.g. mining, or high technology R&D firms
• Methods include
– cash bonus based on share price increases
– shares
– options to shares
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Market-based bonus schemes (cont.)
• Managers have incentives to increase the value of
the firm
• 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
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Choice of accounting versus marketbased bonus schemes
• 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 marketwide movements in equity values
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Debt contracting—agency costs of debt
• Agency costs of debt 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
– investment in high-risk projects may not be beneficial to
debt holders as they have a fixed claim
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Use of debt contracts
• In the absence of safeguards to protect the
interests of debtholders, it is assumed they will
require the firm to pay higher costs of interest to
compensate
• If firms contract not to pay excess dividends, take
on high levels of debt or invest in risky projects,
then they can attract debt at lower cost
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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
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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
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Debt contracts—manager’s incentive to
manipulate
• Ex post, the incentive to manipulate numbers
increases as the constraints approach violation
• Managers found to manipulate accounting
accruals in the years before and the year after
violation of a debt agreement
• Consider HIH
• Too costly to stipulate all acceptable accounting
methods in contract so managers always have
some discretionary ability
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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
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Political costs
• 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
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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
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Actions of politicians
• Politicians know that highly profitable companies
could be unpopular with members of constituency
• Politicians could win votes by taking actions
against the companies
– argue that in public interest even though in own interest
• May rely on reported profits to justify actions
– provides incentives for firms to reduce reported profits
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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
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