Financial Accounting Theory
Craig Deegan
Chapter 7
Positive accounting theory
Slides written by Craig Deegan
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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
– 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 the practice of accounting)
• By contrast, 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 – something common in positive
research
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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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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
that private debt contracts – explained from an efficiency
perspective
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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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