9.403 Chapter 8 Summary Feb. 27, 02
Financial Accounting Theory
Chapter 8 – Summary The Positive Theory of Accounting
8.1 Outline
In the text, Scott defines Positive accounting theory (PAT) as: “concerned with predicting such actions as the choices of accounting policies by firms and h ow firms will respond to proposed new accounting standards.” (263) PAT uses theory to predict the choices that management will make regarding their choice of accounting policies. This theory is introduced as a way to merge efficient securities markets with economic consequences. PAT takes the view that firms will conduct themselves in the way that maximizes their own best interests.
Managers do not always do what is best for shareholders, but what will be the most beneficial to their organization. The choices that an organization makes are dependant on what industry they are in, and the factors within that industry.
An organization can be portrayed by the contracts it enters into. A firm’s contracts with employees, suppliers, lenders, and shareholders are central to its operations. The organization is inclined to keep these contract costs as low as possible. PAT emphasizes that an organization’s choice of accounting policies is motivated by keeping contract costs down. PAT does not propose that organizations completely identify what accounting policies they will use. Such specification is costly to commit to, and does not give management the opportunity to respond to unforeseen circumstances.
Managers have flexibility to choose from a set of accounting policies, and these options let them choose the policies that are the most beneficial to them.
The most favourable accounting policies are a balance of minimal costs, and flexibility to give management the option of changing policies in response to

9.403 Chapter 8 Summary Feb. 27, 02 changes in their external environment. The ultimate objective of PAT is to comprehend and forecast accounting policy choice across different firms, and different industries.
8.2 The Three Hypotheses of Positive Accounting Theory
Positive accounting theory is organized around three hypotheses:
 the bonus plan hypothesis
 the debt covenant hypothesis
 the political cost hypothesis
The bonus plan hypothesis dictates that managers will use accounting policies that are likely to shift reported earnings from future periods to the current period. This is to maximize their personal compensation as by reporting a high net income, their utility will be maximized through bonuses and incentives.
The debt covenant hypothesis states that the closer a firm is to compromising their debt covenants, the more likely management is to use accounting policies that shift reported earnings from future periods to the current period. This is because higher net earnings will reduce the probability of technical default on the debts.
The political cost hypothesis states that the greater the political costs to the firm, the more likely management is to use accounting policies to defer reported earnings from current periods to future periods. This hypothesis brings politics into the choice of accounting policies. Highly profitable firms attract media and consumer attention. This attention can create an increase in taxes and other regulations.
These three hypotheses form the cornerstone of Positive Accounting Theory.
They all lead to empirically verifiable predictions.

9.403 Chapter 8 Summary Feb. 27, 02
8.3 Empirical PAT Research
Positive accounting theory has created a large amount of empirical research.
Lev’s research helped us understand why firms choose the accounting polices they do, why some managers would object to the change in policies, and why investors react the way that they do to changes in net income. Healy discovered that managers in organizations with bonus incentive plans often adopted accrual policies to maximize their expected bonuses. Sweeney studied first-time debt covenant violators, and found that the violators made significantly more voluntary income-increasing accounting policies prior to their default. Firms were also able to manipulate net income with the timing of their adoption of new accounting standards.
Jones investigated the tendency for firms to reduce their reported net income during import relief investigations. These firms have to prove to the government that their income has deteriorated as a result of foreign competition, and deserve assistance such as tariff protection or trade legislation. There is a financial motivation for these organizations to reduce their net income to qualify for relief.
Jones also investigated whether firms used discretionary accruals to lower reported earnings. She concluded that there was a tendency for organizations to manipulate accounting policies relating to accruals.
8.4 Distinguishing the Opportunistic and Efficient Contracting Versions of PAT
Positive accounting theory can be classified as opportunistic and efficient versions. The three hypotheses of PAT are presented in opportunistic form.
Managers choose accounting policies to maximize their own expected utility relative to their bonus plan, debt covenants, and political costs. Management chooses accounting policies that minimize their contract costs. These policies

9.403 Chapter 8 Summary Feb. 27, 02 can also be chosen on an efficiency criterion. Quite often, these two theories make similar forecasts. It is difficult to determine whether opportunism or efficiency is driving the policy changes.
Research has addressed this problem. Christie and Zimmerman investigated the frequency of firms that faced takeover, to use income-increasing accounting policies to maximize reported net income and financial position. They found that these policy changes were not used to avoid possible takeover, and that were not as opportunistic as originally thought.
Sweeney discovered that managers would change accounting policies in response to debt covenant problems, only when it was cost-effective. In another study, Sweeney found that firms that would benefit opportunistically through substantial tax costs from switching accounting policies, chose not to do so – in favour of a more efficient alternative. Her results show support for both the opportunistic and efficient views of hypotheses, and firm specific analysis is required to distinguish between the two. Dechow did research that found net income to be more highly associated with net returns than cash flow.
Subramanyam that manager’s choices of discretionary accruals served to improve the predictive value of current earnings to predict future earnings.
These findings support the efficient contracting version of PAT, as opposed to the opportunistic.
8.5 Conclusion
Positive accounting theory is used to predict and comprehend the accounting policy choices that firms make. It is introduced as a way to merge market theory with economic consequences.

9.403 Chapter 8 Summary Feb. 27, 02
Quiz
True/False Questions
1. The Three Hypotheses of Positive Accounting Theory all lead to empirically testable predictions
2. One would expect that managers of firms with bonus plans would oppose proposed accounting standards that may lower reported net income.
3. Foreign competition may lead to reduced profitability unless affected firms can influence the political process to grant import protection.
4. The sheer size of an organization can lead to political costs.
5. The prospect of covenant violation constrains management’s actions in running the firm.
6. We would expect that managers of firms with bonus plans would welcome proposed accounting standards that may lower reported net income.
7. A firm can be viewed by the set of contracts it enters into, so a firm will want to minimize its various contracting costs associated with these contracts?
8. Sweeney did not support both versions of PAT from her research.
9. A firm can be viewed by the set of contracts it enters into, so a firm will want to minimize its various contracting costs associated with these contracts?
10. Sweeney researched firms that were first time debt covenant violators.
These firms had significantly more voluntary accounting policy changes that decreased income to avoid covenant violation

9.403 Chapter 8 Summary Feb. 27, 02
Multiple Choice Questions
1. The Political Cost Hypothesis states that the closer a firm is to violating debt covenants, the more likely they are to: a) shift reported profits from current to future periods b) make arrangements, to pay back the debt c) shift reported profits from future to current periods d) negotiate to ease the debt covenants
2. Which one of these is not one of the Three Hypotheses of Positive
Accounting? a) The Political Cost Hypothesis b) The Bonus Plan Hypothesis c) The Debt Covenant Hypothesis d) The Normative Opportunistic Hypothesis
3. According to Positive Accounting Theory, if a firm wants to maximize its probability for survival it would: a) organize itself to have a large amount of capital assets b) organize itself in the most efficient manner c) organize itself to have less debts d) organize itself to acquire more dependable employees
4. According to
PAT, the opportunistic form can be stated in “________” form which both make __________ predictions? a) efficiency, different b) efficiency, similar c) positive, different d) positive, similar

9.403 Chapter 8 Summary Feb. 27, 02
5. Positive accounting theory has generated a large amount of ______ research. Lev emphasized on how investors ______ react to the prospect of policy changes in oil and gas firms, not on how firms and investors ______ react. a) nominal, did, should b) nominal, should, did c) empirical, should, did d) empirical, did, should
6. Delaying payment of current liabilities, writing off large amounts of slowmoving inventory , and lowering receivables are all examples of ______. a) total accruals b) negative accruals c) discretionary accruals d) positive accruals
Short Answer Questions
1. Which of the three hypotheses of positive accounting deals with debt, and what is the reasoning behind the hypothesis?
2. Define Opportunistic behavior? Give an example?
3. Briefly describe what Christie and Zimmerman found in their study?
4. Explain how defaulting firms, that Sweeney researched, confirm assumptions of the debt covenant hypothesis and give specific examples of accounting policy changes they used.
5. What are discretionary accruals and give examples of some. How could these accruals be used concerning firms that are unfairly affected by foreign competition

9.403 Chapter 8 Summary Feb. 27, 02
Quiz Answers
True/False
1. True
2. True
3. True
4. True
5. True
6. False
7. True
8. False
9. False
10. False
Multiple Choice
1. C
2. D
3. B
4. B
5. D
6. B
Short Answer
1. The debt covenant hypothesis deals with debt, and it states that all other things being equal, the closer a firm is to violation of accountingbased debt covenants, the more likely the firm manager is to select accounting procedures that shift reported earnings from future periods to the current period.

9.403 Chapter 8 Summary Feb. 27, 02
2. Opportunistic behaviour- Given the available set, managers may choose accounting policies from their set for their own interests.
Ex: Managers who are actively exploring oil companies whose remuneration contracts are based on reported net income may choose full-cost accounting over successful-efforts with the intention to smooth out income and increase the present value of their bonus streams.
3. Christie and Zimmerman found that although firms who have become takeover targets were expected to have behaved opportunistically, showed that income-increasing accounting policies were relatively small.
4. The debt covenant hypothesis implies that a firm's main managerial objective is to minimize problems with creditors. Especially at times where firms are close to violating accounting-based debt covenants, they are more likely to select accounting procedures that shift reported earnings from future periods to the current period. Basically firms choose accounting procedures that increase income to avoid these violations with creditors.
This is exemplified in Sweeney's research. She has shown that in comparison to control sample firms, among years prior to default, the defaulting firms made significantly more voluntary income-increasing accounting policy changes. They did this to avoid violating any covenants to decrease costs incurred, such as, increased security, restrictions on further borrowing, and higher interest rates. Examples of income increasing accounting changes include adoption of FIFO inventory, liquidation of LIFO inventory layers changes in pension plan assumptions, and pension terminations.
5. Discretionary accruals are hard-to-detect manipulations of accounting policy changes relating to accruals. These accrual values are estimated from the professional judgment of firm managers. These values can be increased or decreased depending on the circumstances that the firm faces. Some examples are increase of depreciation and amortization charges, it may record excessive liabilities for product guarantees, contingencies, and rebates, and it may record generous provisions for doubtful accounts and obsolescence of inventories.
Discretionary accruals can be used to report a lower net income during import relief investigations. Firms that are unfairly affected by foreign competition typically need assistance in the form of trade legislation.

9.403 Chapter 8 Summary Feb. 27, 02
Discretionary accruals allow firms to bolster their case of a lower reported net income. The fact that they are hard to detect strengthens disincentives to uncover earnings manipulation by the International Trades
Commission and consumers alike. Thus, making discretionary accruals a good tool for firms to use when relief is needed from foreign competition.