Positive Accounting Theory

Accounting Theory & Standard
Week#10: Positive Accounting Theory
BBA 23rd Batch
Md. Saiful Alam, PhD FCMA

Associate Professor
Dept. of Accounting & Inf. Sys.
University of Dhaka
PAT 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

PAT defined — continued
 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

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
• 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
– 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

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

Origins of PAT—Agency theory
 Explained why the selection of particular accounting

methods might matter
 Focused on the relationships between principals and agents

– eg. shareholders and managers
 Information asymmetries create much uncertainty

– transaction costs and information costs exist

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 decision-making authority to the agent’
 Relies upon traditional economics literature

– 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

Agency costs
• Monitoring costs
– costs of monitoring agents behaviour
– eg. auditing financial statements
• Bonding costs
– costs involved in agents bonding their behaviour to expectations of principals
– eg. preparing financial statements
• Residual loss
– too costly to remove all opportunistic behaviour

Role of accounting in contracts
 Firm is viewed as a nexus of contracts
 Accounting information used to reduce agency costs
 Used as monitoring and bonding mechanisms to control the efforts of

self-interested agents

Agency Relationship
delegation
Principal (owner) Agent (manager)
performance
Solutions:
Problems:
•Bonding
•Self interest
•Monitoring
•Goal congruence
•Residual loss
(reduce performance)
(increase performance)

Key hypotheses
 Three key hypotheses frequently used in PAT literature to explain and predict
support or opposition to an accounting method:
– Bonus Plan Hypothesis

– Derives from managerial incentive contracts
– Debt Covenant Hypothesis

– Derives from debt contracts
– Political Cost Hypothesis

– Very large firms minimize political “heat”

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

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

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 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

 Accounting rules at the reporting date may change as new accounting standards
are issued (rolling/floating GAAP; alternative is Frozen GAAP)

Incentives to manipulate accounting numbers
 Rewarding managers on the basis of accounting profits may induce
them to manipulate 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
- Empirical Results
 Healy (1985)
 When bonuses are linked with a pre-specified level of earnings, evidence found that
managers undertook strategies to claim the bonus
 Strategies of ‘taking a bath’ was evident
 Lewellen at al. (1987)

 US managers approaching retirement were less likely to undertake R&D expenditures if
there rewards were based on accounting-based performance measures
 Horizon problem (horizon of managers are short relative to the life horizon of the firm)

Market-based bonus schemes
• May be more appropriate to remunerate managers in terms of market
value where accounting earnings fluctuate greatly
– eg. mining, high technology R&D firms
• Methods include:
– cash bonus based on share price increases
– shares
– options to shares

• managers have incentives to increase the value of the firm
• problems include:
– share price also affected by factors beyond the control of managers, eg.
general market movements
– only senior managers likely to have a significant impact on share value

Market-based bonus schemes- Empirical
Results
• Nagar et al. (2003)
– Providing managers with equity interests (for example, shares or share options) in
the organization will act to reduce the ‘non-disclosure tendency’.
– Firm disclosures, measured both by the frequency of earnings forecasts and
analysts’ rating of the firms’ disclosures, increase as the proportion of CEO
compensation tied to the share prices, and the value of CEO shareholdings,
increase.

A Recent Example
• Pfizer CEO Sold Millions In Stock After Coronavirus Vaccine News,
Raising Questions (November 11, 2020)
• C:\Users\Lenovo-
PC\Downloads\20201111_atc_npr_investigation_is_pfizers_ceo_involv
ed_in_insider_trading.mp3

Choice of accounting versus market-based
bonus schemes
• More likely to be based on accounting earnings where (Sloan, 1993):
– Share returns relatively more sensitive to general market movements
– Accounting earnings have a high association with firm-specific movement in the

firm’s share values
– Earnings have a less positive (more negative) association with market-wide

movements in equity values

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

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

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

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

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

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 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

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

An Example
• The BP oil spill, also called the Gulf oil spill,
was the biggest ever in U.S. waters. Worse
than the Exxon Valdez oil spill, it was one
of the world’s worst environmental
disasters
• On January 16, 2018, BP PLC announced

it would take a $1.7 billion charge for
expenses related to the 2010 Deepwater
Horizon oil spill.
• It expects cash payments of $3 billion for

the year. As of July 14, 2016, BP had spent
$61.6 billion in court fees, penalties, and
clean-up costs.

Empirical Results
• Sutton (1988)
– Politically sensitive companies were also more likely to lobby in favour of current
cost accounting which had the effect of reducing reported profits
• Ness and Mirza (1991)

– Particular voluntary social disclosures in an organization’s annual report can be
explained as an effort to reduce the political costs of the disclosing entities
– Oil companies provided greater environmental disclosures within their annual

reports than did companies operating in other industries

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

Efficiency perspective— continued
• PAT theorists argue that regulation forcing firms to
use a particular accounting method imposes
unwarranted costs

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

Distinguishing Opportunistic v. Efficiency versions of PAT,
conclusion
• Conclude: significant evidence in favour of efficiency version of PAT
• This implies that the inherent conflict between investor and manager interests is reasonably
controlled
▫ This is usually done by
 Compensation package
 GAAP – full disclosure – correlation between performance measure and effort
 Audit committee involvement
 Intense monitoring of manager
 Sarbanes-Oxley Act
 Independent boards of directors

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

Criticisms of PAT - continued
• Measurements and proxies used are too simplistic
• Scientifically flawed
• Cannot fully explain human action
• Assumes an objective reality
– realist philosophy

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Accounting Theory & Standard

Week#10: Positive Accounting Theory

BBA 23rd Batch

Md. Saiful Alam, PhD FCMA

12/16/2020 DMSA_Accounting Theory_DU_AIS 2

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– owners and managers

– managers and the firm’s debt providers

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• Dominant research paradigm in 1970s and 1980s

12/16/2020 DMSA_Accounting Theory_DU_AIS 6

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• Literature unable to explain why particular accounting methods

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 Explained why the selection of particular accounting

 Focused on the relationships between principals and agents

 Information asymmetries create much uncertainty

12/16/2020 DMSA_Accounting Theory_DU_AIS 9

 Relies upon traditional economics literature

12/16/2020 DMSA_Accounting Theory_DU_AIS 10

 Agents will therefore have incentives to enter contracts which appear

12/16/2020 DMSA_Accounting Theory_DU_AIS 11

12/16/2020 DMSA_Accounting Theory_DU_AIS 12

 Accounting information used to reduce agency costs

 Used as monitoring and bonding mechanisms to control the efforts of

12/16/2020 DMSA_Accounting Theory_DU_AIS 13

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– Bonus Plan Hypothesis

– Debt Covenant Hypothesis

– Political Cost Hypothesis

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• managers have access to information not always available to principals

– further increases managers ability to undertake activities beneficial to

• costs of divergent behaviour are agency costs

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 Managers may contract themselves not to consume perks so will receive

12/16/2020 DMSA_Accounting Theory_DU_AIS 18

 Salary plus remuneration in part tied to firm performance

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 All based on output from the accounting system

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

 Contracts in some circumstances may be based on the old method in

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

12/16/2020 DMSA_Accounting Theory_DU_AIS 21

– 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

12/16/2020 DMSA_Accounting Theory_DU_AIS 22

 Strategies of ‘taking a bath’ was evident

 Lewellen at al. (1987)

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

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