POSITIVE ACCOUNTING THEORY (PAT)
1. Bonus plan hypothesis
2. Debt covenant hypothesis
3. Political cost hypothesis
ASNUR FATEM ALI
INTRODUCTION
◦ 1) Positive Accounting Theory (PAT) concerned with predicting such actions as
the choices of accounting policies by firms & how firms will respond to
proposed new accounting standard.
◦ 2) PAT uses theory to predict the choices that management will make
regarding their choice of accounting policies.
◦ 3) This theory is introduced as a way to merge efficient securities markets with
economic consequences.
◦ 4) PAT takes the view that firms will conduct themselves in the way that
maximizes their own best interests.
◦ 5) Managers do not always do what is best for shareholders, but what will be
the most beneficial to their organization.
◦ 6) The choices that an organization makes are dependant on what industry
they are in, and the factors within that industry.7) PAT emphasizes that an
organization’s choice of accounting policies is motivated by keeping contract
costs down.
INTRODUCTION (CON..)
Bonus plan
hypothesis
Opportunistic
Positive
Accounting
Theory
Perspective
Efficiency
Perspective
Debt
covenant
hypothesis
Political cost
hypothesis
BONUS PLAN
HYPOTHESIS
INTRODUCTION
◦ 1) Assumes that managers with bonus plan (tied to reported) as
more likely to use accounting methods that increase current
period reported income.
◦ 2) It predicts that if a manager is rewarded in terms of a measure
of performance such as accounting profits, the manager will
attempts to increase profits.
INTRODUCTION (continue)
◦ 3) Managers use discretionary accruals to maximize their short-term bonus (Healy 1985)known as Bonus Maximization Hypothesis.
- use discretionary accruals to manipulate earning (discretionary accounting is nonobligatory expenses-such as bonus & bad debt provision that is yet to be realized
but recorded in the account book. A company may or may not be be recognize
this expenses).
- Healy’s Finding : Managers observe income before discretionary accruals and
make either income-increasing or decreasing discretionary accruals based on
company bonus plan:
i) Income-decreasing when income before discretionary accruals is below the
lower bound or above the upper bound-they anticipate increasing the
probability of earning a bonus in future.
ii) Income-increasing when income before discretionary accruals falls between
the upper and lower bound- they can get higher bonus in the current period.
EXECUTIVE COMPENSATION,
INVESTMENT OPPORTUNITIES,
AND EARNINGS
MANAGEMENT:HIGH-TECH
FIRMS VERSUS
LOW-TECH FIRMS
Author : 1) Sun S.Kwon
(School of Administrative Studies ,Atkinson College, York University)
2) Qin Jennifer Yin
(Department of Accounting, College of Business, University of Texas at
San Antonio)
Published in : Journal of Accounting, Auditing and Finance, 21(2), 2006, pp. 119148.
EXECUTIVE COMPENSATION, INVESTMENT OPPORTUNITIES, AND EARNINGS
MANAGEMENT: HIGH-TECH FIRMS VERSUS LOW-TECH FIRMS
INTRODUCTION
1) Questions exist on whether high-tech firms and low-tech firms use performance measures,
including stock and accounting performance, in the same way when determining
compensation contracts.
2) Prior research indicates that the market valuation for high-tech stocks differs from that for
traditional stocks.
3) Hand (2000) asserts that the conventional assumption that accounting information maps into the
equity market value in a linear and stationary manner is not relevant to technology-intensive
firms.
4) Although the relevance of performance measures for valuing a firm may differ for executive
contracting purposes, the link between executive pay and reported earnings is sensitive to the
underlying value in earnings (Bushman et al. [2000]).
EXECUTIVE COMPENSATION, INVESTMENT OPPORTUNITIES, AND EARNINGS
MANAGEMENT: HIGH-TECH FIRMS VERSUS LOW-TECH FIRMS
INTRODUCTION (Con..)
5) The nature of the high-tech business may provide one possible reason for these differences. Hightech firms must invest more in such intangible assets as R&D, human resources, customer acquisition,
brand development, and other information technology in comparison to low-tech firms.
6) To survive in the fast-changing, fiercely competitive high-tech market, these firms also incur
greater and more frequent unusual or nonrecurring expenses, including :
7) inventory write-downs, restructuring/ reorganization expenses, and write- downs or write-offs of
receivables and intangibles that potentially lower their earnings reports.
8) Further, investment projects typically are more difficult to observe and monitor than assets-inplace (Smith & Watts [1992]; Krishnan & Kumar [2001]), and
9) This increases the information asymmetry between the principal (shareholders) and the agent
(managers) in high-tech firms, creating a need to monitor managers’ performance through
compensation contracts (Jensen & Meckling [1976]; Fama & Jensen [1983]).
EXECUTIVE COMPENSATION, INVESTMENT OPPORTUNITIES, AND EARNINGS
MANAGEMENT: HIGH-TECH FIRMS VERSUS LOW-TECH FIRMS
COMMAND HIGHER LEVELS OF
COMPENSATION FOR THE INFORMATIONAL
ADVANTAGES
* CEOs provide on investment projects
and increased risk exposure related to
investment opportunities
TO REDUCE AGENCY COSTS ARISING FROM
INFORMATIONAL ASYMMETRY
* To tie CEO compensation closely to
managerial efforts of accomplishing
investment goals in the best interest of their
shareholders
WHY HIGH-TECH FIRMS USE THE COMPENSATION INSENTIVES (DISCRETIONARY ACCRUAL)
HIGH-TECH FIRMS INCUR LARGE EXPENSES TO GENERATE AND EXPLOITINVESTMENT OPPORTUNITIES
THAT POTENTIALLY LOWER ACCOUNTINGEARNINGS.
• If high-tech firms base large portions of managers’ compensation on accounting earnings, it may
encourage such undesired management behaviour as becoming myopic and forgoing projects
that reduce current earnings but have positive net present value.
• Using long-term incentives alleviates the horizon problem and avoids penalizing managers for
activities that improve the long-term prospects of the company but reduce current income.
• Thus, high-tech firms’ compensation contracts are likely to emphasize the relative use of stockbased performance measures and tie compensation to stock returns.
EXECUTIVE COMPENSATION, INVESTMENT OPPORTUNITIES, AND EARNINGS
MANAGEMENT: HIGH-TECH FIRMS VERSUS LOW-TECH FIRMS
COMMAND HIGHER LEVELS OF
COMPENSATION FOR THE INFORMATIONAL
ADVANTAGES
* CEOs provide on investment projects
and increased risk exposure related to
investment opportunities
TO REDUCE AGENCY COSTS ARISING FROM
INFORMATIONAL ASYMMETRY
* To tie CEO compensation closely to
managerial efforts of accomplishing
investment goals in the best interest of their
shareholders
WHY HIGH-TECH FIRMS USE THE COMPENSATION INSENTIVES (DISCRETIONARY ACCRUAL)
HIGH-TECH FIRMS INCUR LARGE EXPENSES TO GENERATE AND EXPLOITINVESTMENT OPPORTUNITIES
THAT POTENTIALLY LOWER ACCOUNTINGEARNINGS.
• If high-tech firms base large portions of managers’ compensation on accounting earnings, it may
encourage such undesired management behaviour as becoming myopic and forgoing projects
that reduce current earnings but have positive net present value.
• Using long-term incentives alleviates the horizon problem and avoids penalizing managers for
activities that improve the long-term prospects of the company but reduce current income.
• Thus, high-tech firms’ compensation contracts are likely to emphasize the relative use of stockbased performance measures and tie compensation to stock returns.
EXECUTIVE COMPENSATION, INVESTMENT OPPORTUNITIES, AND EARNINGS
MANAGEMENT: HIGH-TECH FIRMS VERSUS LOW-TECH FIRMS
◦ RESEARCH OBJECTIVE
◦ 1) Examine the systematic differences between high-tech & lowtech firms in compensation policies.
◦ 2) Examine the sensitivity of compensation to market &
accounting performance.
◦ 3) Examine earning management in the presence of investment
opportunities.
EXECUTIVE COMPENSATION, INVESTMENT OPPORTUNITIES, AND EARNINGS
MANAGEMENT: HIGH-TECH FIRMS VERSUS LOW-TECH FIRMS
◦ HYPHOTHESIS
1) High-tech firms pay higher levels of executive compensation than low-tech firms
2) High-tech firms payless in cash salaries and bonuses but offer more stock options than low-tech
firms
3) The Association between changes in compensation and changes in stock performance is higher,
and the association between changes compensation and changes in accounting performance
is lower, for high-tech firms than for low-tech firms.
4) The Association between compensation discretionary accruals is higher in high-tech firms than in
low-tech firms, especially when earning before discretionary accruals are lower than analysts’
earnings forecast
EXECUTIVE COMPENSATION, INVESTMENT OPPORTUNITIES, AND EARNINGS
MANAGEMENT: HIGH-TECH FIRMS VERSUS LOW-TECH FIRMS
◦ SENSITIVITY TEST (CONFOUNDING FACTORS)
• SIZE EFFECT
 Compensation relates to firm size :
- large firm typically have more complex structures and require a greater level of managerial effort than small
firms
- Even Though firm size does not differ significantly between high-tech and low-tech firms it may have affected
previous regression results because firm size was not explicitly controlled for in the regression
• REGULATION EFFECT
 executive compensation varies inversely with levels of regulation because regulations restrict the chief
executive officer’s investment discretion and reduce the marginal product of the decision
• DEBT EFFECT
 Debt to-asset ratios differ significantly between high-tech and low-tech firms, so it is particularly important to
control for the effect of debt.
EXECUTIVE COMPENSATION, INVESTMENT OPPORTUNITIES, AND EARNINGS
MANAGEMENT: HIGH-TECH FIRMS VERSUS LOW-TECH FIRMS
◦ CONCLUSION
1) high-tech firms generally pay a higher level of total compensation than low-tech firms.
2) high-tech firms use lower cash salaries and bonuses but larger amounts of stock options
grants when rewarding CEOs
3) the association between compensation and stock returns is higher for high-tech firms, and
find no difference in the association between compensation and accounting returns in
both groups
4) the positive association between bonus and discretionary accruals is higher for high- tech
firms than for low-tech firms, especially when earnings before discretionary accruals are
lower than the mean earnings forecast.
5) The results are robust to various sensitivity analyses, including controlling for potentially
confounding effects related to size, debt, and regulation; using alternative specifications of
accounting and market performance measures; and a variety of procedures to attenuate
the effects of extreme values.
6) The overall results indicate systematic differences between high-tech and low-tech firms in
compensation policies, choices of performance indicators, and the treatment of earnings
management. The interpretation is that differences in information environment between
high-tech and low-tech firms lead to different structures for compensation contracts.
DEBT COVENANT
HYPOTHESIS
DEBT COVENANT HYPOTHESIS
◦ Debt covenant
• Restrictions placed on a borrower/ bond issuer by the lender/ bank that granted
the loan/ credit via loan agreement (normally) or in a separate agreement.
• Debt Covenant - An agreement between lender and borrower that enable lender
to place a limit on:
 Payment of dividend
 Production and investment
 Issuance of new debt
Payoff pattern
 Accounting ratios
DEBT COVENANT HYPOTHESIS (Con..)
◦ Attempts to limit managers ability to transfer assets to themselves, new shareholders, or
new creditors.
• Violation of covenant - immediate payment of principal and interest
• Renegotiating the terms of the debt:
Accelerated the principal payment
 Increase interest rate
 Liens on assets
 Other restriction on accounting ratio and activities
• Overall higher cost to the company
DEBT COVENANT HYPOTHESIS (Con..)
• 2 types :- positive/ affirmative covenant : require certain actions. E.g
require a borrower to maintain certain level of financial ratios or
capital
- negative covenant : limits certain actions. E.g. a borrower is
prevented from taking more debt backed by its assets
DEBT COVENANTS AND
ACCOUNTING CONSERVATISM
BY VALERY V. NIKOLAEV
Author : Valeri V.Nikolaev (The University of Chicago Booth School of
Business)
Published in : Journal of Accounting Research Vol. 48 No. 1 March 2010
Purpose of study - test whether firm that rely on covenants in their public
debt contracts recognize economic losses in earnings in a more timely
fashion.
ROLE OF DEBT COVENANT
• Debt covenant limit a manager’s ability to opportunistically expropriate
wealth from bondholder when a firm approach economic distress.
• But this only become binding if the accounting system recognize the
deterioration of company’s financial position.
• Timely loss recognition is expected to improve the efficiency
more likely to binding in distress
Thus, limit opportunistic action by manager.
ROLE OF TIMELY LOSS RECOGNITION
AND THE USE OF COVENANTS
Timely loss recognition enhance efficiency of debt contracting
in:
By facilitate early transfer of decision right to bondholders
Facilitate the signalling role of covenants.
HYPOTHESES
Timely recognition of economic losses increase with the use of
debt covenants in public debt contract
Companies that rely on debt covenants more extensively exhibit
a greater increase in timely recognition of economic losses
following debt issue.
FINDING
Public debt contract employ more covenants exhibit timelier
recognition of economic losses
Exhibit higher level of timely loss recognition both before and
after the issue
Extensively experience an increase in timely loss recognition after
the issue. Thus, use of covenants in public debt contracts is
associated with increased demand for timely loss recognition.
POLITICAL COST
HYPOTHESIS
POLITICAL COST
◦ The term political costs is used to refer to the costs that particular
groups external to the firm might be able to impose on the firm,
such as the costs associated with increased taxes, increased
wage claims or product boycott.
◦ Government, trade unions, environmental lobby groups or
particular consumer groups affect organizations.
POLITICAL COST (conts)
◦ The demands placed on firms by particular interest groups might
be affected by the accounting results of the firm.
◦ For example, if a firm were to record high profits, this might be
used as an excuse for the trade unions to take action to increase
their members’ share of profits in the form of higher wages.
POLITICAL COST (conts)
◦ High profits might also be used by particular groups that lobby for
increased taxes or decreased subsidies on grounds of the firm’s
ability to pay.
◦ For example, Watts and Zimmerman (1986) examined the highly
publicized claims about US oil companies made by consumers,
unions and government within the USA in late 1970s.
◦ These claims were that oil companies were making excessive
reported profits and were in effect exploiting the nation.
◦ It is considered that such claims could have led to the imposition
of additional taxes in the form of ‘excess profits’ taxes.
POLITICAL COST (conts)
◦ Governments seeking re-election could be motivated to take
action against unpopular firms if it was felt that they would secure
a net increase in electoral support.
◦ This obviously assumes that the actions of most politicians are
motivated by a desire to be re-elected – perhaps not an
unrealistic assumption and certainly consistent with the PAT
contention that actions of all individuals can best be explained
by the assumption of self interest.
◦ It is argued within PAT that accounting numbers can be used as
a means of providing ‘excuses’ for effecting wealth transfers in
the political process.
POLITICAL COST (conts)
◦ High profits might also be used by consumer groups to justify
assuming a position that prices are too high.
◦ Media reports of high corporate profitability trigger political costs
of a firm.
POLITICAL COST (conts)
◦ In a sense, the reported accounting profits of particular
organizations are used as an excuse to push for higher wages,
which could be costly for these organizations.
◦ However, if reported profits were not so high, perhaps this would
reduce the likelihood of demands for increased wages.
◦ Therefore, if managers consider that there might be claims for
increased wages in particular years, those managers might elect
to adopt income-decreasing accounting methods.
◦ For example, they might depreciate assets over fewer years,
thereby increasing depreciation expenses and consequently
reducing profits.
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