Accounting theory 9

An overview of Positive Accounting Theory

From Deegan, C. and Samkin, G., Financial Accounting. McGraw-Hill Irwin,

New York Prepared By: Dewan Mahboob Hossain;

Assistant Professor; Department of Accounting & Information Systems;

University of Dhaka; Dhaka; Bangladesh.

Prepared By: Dewan Mahboob Hossain

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Positive theories

• Positive theories seek to explain and predict particular phenomena.

• They are often developed and supported on the basis of observations (that is, they are empirically based).

• The view is that by making numerous observations one will be in a better position to predict what will happen in future.

• For example, many managers within a particular industry might be studied to predict what accounting methods they will elect to use in particular circumstances.


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Positive Accounting Theory (PAT)

• Seeks to explain and predict accounting practice.

• It does not seek to prescribe particular actions.

• According to Watts and Zimmerman:“[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 [accounting] method….but it says nothing as to which method a firm should use.”

• Normative accounting theories have criticized PAT because it does not provide practitioners with guidance, even though it does attempt to explain the economic implications that might result from the selection of particular accounting policies.


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Positive Accounting Theory (PAT)…contd..

• Some examples of positive theories are: legitimacy theory and stakeholder theory.

• Watts and Zimmerman’s PAT focuses on the relationship between the various individuals involved in providing resources to the organization.

• This could be the relationship between the owners and the managers, or between the managers and the firm’s debt providers.


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• Many relationships involve the delegation of decision making from one party (the principal) to another party (the agent) – this is referred to as an agency relationship.

• Delegating decision making authority can lead to loss of efficiency and, consequently, increased costs. These costs are called agency costs.

• PAT investigates how contractual arrangements- many tied to accounting numbers- can be put in place to minimize agency costs.


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• PAT investigates how contractual arrangements- many tied to accounting numbers- can be put in place to minimize agency costs.

• PAT is developed on the assumption that all individual action is driven by self interest and that individuals will act as an opportunistic manner to increase their wealth.

• Notions of loyalty and morality are not accommodated within the theory.


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• Organizations are considered as collections of self-interested individuals who have agreed to cooperate.

• Such cooperation does not mean that they have abandoned self-interest as an objective; rather it means only that they have entered into contracts that entail sufficient incentives to secure their cooperation.


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• PAT predicts that organizations will seek to put in place mechanisms that align the interests of the managers of the firm (the agents) with interest of the owners of the firm (the principals).

• Some of these methods of aligning interests will be based on the output of the accounting system, such as, providing the managers with a share of the organizations’ surpluses.

• Where such accounting based alignment mechanisms are in place, financial statements will need to be produced.


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• Managers are required to bond themselves to prepare these financial statements. This is costly in itself and, in PAT, would be referred to as a bonding cost.

• This bonding cost is a cost incurred by agents when they establish mechanisms to signal to principals that they will behave in the interests of the principal or will compensate the principal if they fail to do so.


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• Assuming that managers will be responsible for preparing financial statements, PAT would also predict that there would be a demand for those statements to be audited or monitored.

• Otherwise, assuming self interest, agents would make an attempt to overstate profits, thereby increasing their absolute share of profits.

• In PAT, costs of undertaking an audit is referred to as a monitoring cost.


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• PAT assumes that not all opportunistic actions of agents can be controlled by contractual arrangements or otherwise, there will always be some residual costs associated with appointing an agent.


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Agency Relationship

Principal (owner) Agent (manager)

Solutions:

•Bonding

•Monitoring

•Residual loss

(increase performance)

Problems:

•Self interest

•Goal congruence

(reduce performance)

performance

delegation


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Efficiency and the opportunistic perspectives of

PAT

Research that apply PAT typically adopt either an efficiency perspective or an opportunistic perspective.


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Efficiency perspective of PAT

• From the efficiency perspective, researchers explain how various contracting mechanisms can be put in place to minimize the agency costs of the firm.

• The efficiency perspective is often referred to as an ex ante (before the fact) perspective. It considers what mechanisms are put in place up front with the objective of minimizing agency cost.


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• For example: preparing F/S though not any regulation.

• Researchers such as Jensen and Meckling (1976) argue that the practice of providing audited financial statements leads to real cost savings as it enables organizations to attract funds more cheaply (in other words, it is efficient).


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• From the efficiency perspective of PAT, it is also argued that the accounting practices adopted by firms are often explained on the basis that such methods best reflect the underlying financial performance of the entity.

• Different organizational characteristics are used to explain why firms adopt the accounting methods they do.

• For example: Goodwill.


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• By providing measure of performance that best reflect the underlying performance of the firm, it is argued that investors and other parties will not need to gather additional information from other sources. This will consequently lead to cost savings. for example: Consolidated FS prepared voluntarily.


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Efficiency perspective of PAT (contd..)

• If it is assumed, consistent with the efficiency perspective, that firms adopt particular accounting methods because they best reflect the underlying performance of the entity, it is often argued by the PAT theorists that the regulation of financial accounting imposes unwarranted costs on reporting entities.


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Efficiency perspective of PAT (contd..)

• For example, if a new financial reporting standard is released that bans accounting methods from being used by a particular organization, this will lead to inefficiencies as the resulting financial statements will no longer provide the best reflection of the performance of the organization.

• Many PAT theorist would argue that management is best able to select which accounting methods are appropriate in given circumstances and government should not intervene in the process (an anti-regulation argument).


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Opportunistic perspective of PAT

• The opportunistic perspective of PAT takes as given the negotiated contractual arrangements of the firm and seeks to explain and predict certain opportunistic behavior that will subsequently occur.

• The opportunistic perspective is often referred to as ex post (after the fact) perspective. Because it considers opportunistic actions that could be undertaken once various contractual arrangement have been put in place.


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Opportunistic perspective of PAT (contd..)

• For example, in an endeavor to minimize agency costs, a contractual arrangement might be negotiated that provides managers with a bonus based on the profits generated by the entity.

• This will act to align the interests of the managers with the interests of the owners.

• Once the contractual arrangement is in place, the managers could opportunistically elect to adopt particular accounting methods that increase accounting profits and therefore the size of the bonus. Managers might elect to adopt a particular depreciation method that increases income even though it might not reflect the actual use of the asset.


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Opportunistic perspective of PAT (contd..)

• PAT assumes that principals predict that managers will be opportunistic.

• With this in mind principals often stipulate the accounting methods to be used for particular purpose.

• For example, a bonus plan agreement might stipulate that a particular depreciation method such as straight line depreciation be adopted to calculate income for determination of bonus.

• However, it is assumed to be too costly to stipulate in advance all accounting rules to be used in all circumstances.

• Therefore, PAT proposes that there will always be scope for agents to opportunistically select particular accounting methods in preference to others.


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Owner/manager contracting• A manager that owns a firm bears the costs

associated with their own perquisite consumption (consumption by employees of non-salary benefits), which could include consumption of the firm’s resources for private purposes – acquiring an overly expensive company car or luxurious offices or staying in overly expensive hotel accommodation.

• As the percentage of ownership held by managers decreases, managers bear less and less of the cost of their own perquisite consumption.

• The costs begin to be absorbed by other owners of the firm.


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Owner/manager contracting (contd..)

• PAT adopts as a central adoption that all action by individuals is driven by self-interest, and the major interest of all individuals is to maximize their own wealth. Such assumption is often referred to as the “rational economic person assumption”.

• If all individuals are assumed to act in their own self-interest, owners would expect managers (their agents) to undertake their activities that might not always be in the interests of the owners (the principals).


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• Further, because of their position within the firm, managers will have access to information that is not available to principals – a problem referred to as “information asymmetry”.

• It increases the scope for managers to undertake actions that are beneficial to themselves at the expense of the owners.


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• It is assumed in PAT that principals expect their agents to undertake activities that might be advantageous to themselves but disadvantageous to the value of the firm.

• As a result, principals will price this into the amounts they are prepared to pay the managers.

• That is, in the absence of controls to reduce the ability of managers to act opportunistically, principals expect such actions, and as a result, will pay their managers a lower salary.

• It is often referred to as price protection. Managers, therefore, bear some of the agency costs of the potential opportunistic behaviors that they might, or might not undertake.


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• Before agreeing to increase the amount paid to managers, the owners of a firm would need to ensure that any contractual commitments can be monitored for compliance.

• Managers may be rewarded:1. In a fixed basis;2. On the basis of results achieved, or,3. On the basis of a combination of the

two.


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• If managers are rewarded on a fixed basis:- They will not want to take great risks as they

will not share potential gains. - Will not adopt strategies that will increase the

value of the firm;- They will be reluctant to take on optimum

level of debt as the claims of the debt holders would compete the manager’s own fixed income.

Like debt holders, managers with a fixed income claim want to protect their fixed income stream.


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• Assuming self interest drives actions of managers, PAT theorist argue that it can be necessary to put into place remuneration schemes that reward the managers in a way that is, at least in part, tied to the performance of the firm.

• Thus, if the performance of the firm improves, the rewards paid to managers increase correspondingly. If the firm performs well both the parties will benefit.


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• Bonus schemes: A scheme where the manager receives a

bonus that is ties to the performance of the organization.

Managers are commonly rewarded in terms of the market price of the firm’s shares.

This might be through holding an equity interest in the firm, or perhaps by receiving a cash bonus explicitly tied to movements in the market value of the firm’s securities.


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Accounting based bonus plans

• The amount paid to managers may be tied directly to accounting numbers- such as profits/sales/assets.

• In this case any changes in the accounting methods used by organization will affect the bonuses paid.

• Contracts that rely on accounting numbers might rely on ‘floating’ generally accepted accounting principles.


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Incentives to manipulate accounting numbers

• There are a number of costs that might arise if incentive schemes are based on accounting outputs.

• Healy (1985) found that under schemes that rewarded managers after a pre-specified level of earnings had been reached, managers would adopt accounting methods consistent with maximizing that bonus.

• Where profits were not expected to reach the minimum level required by the plan, managers appeared to adopt strategies that further reduced income in that period (taking a bath).

• This leads to higher income in subsequent periods when profits might be above the requires threshold.

• For example, a manager might write off an asset in one period when bonus was not going to be earned anyway so that there would be nothing further to depreciate in future periods when profit-related bonuses might be paid.


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Incentives to manipulate accounting numbers (contd..)

• Investment strategies that maximize the present value of a firm’s resources will not necessarily produce uniform periodic cash flows or accounting profits.

• It is possible that some strategies might generate minimal accounting returns in the early years, yet still represent the best alternatives available to the firm.

• Rewarding managers on the basis of accounting profits might discourage them from adopting such strategies and might encourage them, instead, to adopt a short term, as opposed to a long-term focus.


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Incentives to manipulate accounting numbers (contd..)

• Lewellen, Loderer and Martin (1987):US managers approaching retirement are less likely

to undertake research and development expenditure if their rewards are based on accounting based performance measures, such as profits.

Incurring R&D costs leads directly to a reduction in profits.

Also R&D expenditures would be expected to lead to benefits in subsequent years, retiring managers might not be there to share that gain.

Predictably, the self-interested manager who is rewarded on the basis of accounting profits will not undertake research and development in periods close to the point of their retirement.


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Market based bonus schemes

• Firms involved in mining or high-technology R&D might have accounting earnings that fluctuate greatly. Successful strategies might be employed that will not provide accounting earnings for a number of periods.

• In such industries, positive accounting theorists might argue that it is more appropriate and efficient to reward managers in terms of the market value of the firm’s securities, which are assumed to be influenced by expectations about the net present value of expected future cash flows.

• This can be done either by basing a cash bonus on any increases in share prices or by providing managers with shares or options to shares in the firm.

• If value of the firm’s share increases, both managers and owners will benefit and managers will be given an incentive to increase the value of the firm.


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Concluding remarks

• PAT assumes that if a manager is rewarded on the basis of accounting numbers, the manager will have an incentive to manipulate the accounting numbers in an effort to increase their own personal wealth.

• Rewarding managers in terms of accounting numbers might not be appropriate if management is solely responsible for compiling those numbers.

• The auditor will act to arbitrate on the reasonableness of the accounting methods adopted.


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Concluding remarks

• It must be remembered that there will always be scope for opportunism.

• It would be too expensive and impossible to pre-specify a complete set of accounting methods to cover all circumstances.

• It should be remembered that the existing accounting standards (IAS and IFRS) do not cover all types of transactions and, as a result, significant discretion can be employed when compiling financial statements.


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Debt Contracting• When a party lends fund to another organization, the

recipient of funds might undertake activities that reduce or even eliminate any likelihood of the funds being repaid.

• These costs, which relate to divergent behavior of the borrower, are referred to in PAT as the agency costs of the debts.

• For example, the recipient of funds might pay excessive dividends, leaving few assets in the organization to service debts.

• Alternatively, the organization might take on additional, and perhaps excessive levels of debt. The new debt holders would then compete with the original debt holders for repayment.

• Smith and Warner (1979) refer to this practice as claim dilution.


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Debt contracting (contd..)

• The firm may also invest in very high-risky projects. The strategy would not be beneficial for the debt holders.

• They have a fixed claim and therefore if the project generates high profits they will receive no greater return, unlike owners who will share the increased value of the firm.

• If the project fails, which is more likely if it is risky, the debt holders might receive nothing.


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• Where covenants restrict the total level of debt that may be issued, this is assumed to lead to a reduction in the risk to existing debt holders.

• This is further assumed to translate into lower interest rates being charged by the protected debt holders.

• Debt covenants are restrictions within a trust deed on the operations of a borrowing entity.


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• In the absence of contractual safeguards, it is assume that the debt holders will require the firm to pay higher costs of interest to compensate high risk exposure.

• If a firm contractually agrees that it will not pay excessive dividends, not take on high levels of debt and not invest in projects of an excessively risky nature, it is assumed that the firm will be able to attract debt capital at a lower cost than would otherwise be possible.


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• As with management compensation contracts, PAT assumes that the existence of debt contracts provides management with subsequent (ex-post) incentives to manipulate accounting numbers – an incentive that increases as the accounting based constraint approaches violation.


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• If the firm contractually agreed that the ratio of debt to total tangible assets should be kept below a certain figure, if the figure was likely to be exceeded, management might have an incentive either to inflate assets or deflate liabilities.

• Debt agreements typically require that financial statements be audited.


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• Debt holders are external parties with a claim against the organization for repayment of funds previously advanced.

• Within accounting, management usually has available a number of alternative ways to account for particular items and thus, to minimize the effects of existing accounting based restrictions.

• Therefore, it might appear optimal for debt holders to specify in advance all accounting methods management must use.


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• However, as noted previously, it would be too costly and impractical to write ‘complete’ contracts upfront.

• As a consequence, management will always have some discretionary ability that might enable it to lessen the effects of restrictions negotiated by debt holders.


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• The role of the external auditors, if appointed, would be to arbitrate on the reasonableness of accounting methods chosen.

• There will be a particular demand for financial statement audit when: a) management is rewarded on the basis of numbers generated by accounting systems; and, b) the firm has borrowed funds and accounting based covenants are in force to protect the investment of debt holders.


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• It could also be argued that as managers’ share of equity in a business decreases and the proportion of debt to total assets increases, there will be a corresponding increase in the demand for auditing.


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Political costs

• 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.


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Political costs (contd.)

• 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.


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Political costs (contd.)• 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.


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Political costs (contd.)• 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.


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Political costs (contd.)

• 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.


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Political costs (contd.)• 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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Accounting policy selection and disclosure

• A firm might be involved in many agreements that use accounting numbers relating to profits and assets.

• As a result, the decision to expense or capitalize an item can have important financial implications for the organization and, potentially, for management.


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Accounting policy selection and disclosure (contd..)

• As a result of the choices that face the accountant, it is imperative that financial report users be aware of the accounting policies adopted by the reporting entity.

• Comparing the financial results and positions of reporting entities that use different accounting methods can be a misleading exercise unless notional adjustments are made to counter the effects of these different methods and policies.

• For such adjustments, knowledge of each firm’s accounting policies is necessary.


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Accounting policy notes

• Notes showing accounting principles, based on recognition and measurement rules adopted in preparing and presenting financial statements.


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Management of Income• Common labels for the financial numbers game:

Label Definition Aggressive accounting

A forceful and intentional choice and application of accounting principles done in an effort to achieve desired results, typically higher current earnings, whether the practices followed are in accordance with GAAP or not.

Earnings management

The active manipulation of earnings toward a predetermined target, which may be set by management, a forecast made by analysts, or an amount that is consistent with a smoother, more sustainable earnings stream.

Income smoothing

A form of earnings management designed to remove peaks and valleys from the normal earning series, including steps to reduce and store profits in good years for use during the slower years.

Fraudulent financial reporting

Intentional misstatements or omissions of amounts or disclosures in financial statements, done to deceive financial statement users, that are determined to be fraudulent by an administrative, civil or criminal proceedings.

Creative accounting

Any and all steps used to play the financial numbers game, including the aggressive choice and application of accounting principles, fraudulent financial reporting, and any steps taken towards earnings management or income smoothing.


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Rewards of the GameThe rewards of the financial numbers game are as follows:

Category rewardsShare price effects

•Higher share prices;•Reduced share price volatility;•Increased corporate valuation;•Lower cost of equity capital;

•Increased value of stock options.

Borrowing cost effects

•Improved credit quality;•Higher debt rating;•Lower borrowing costs;•Less stringent financial covenants.

Bonus plan effects

Increased profit-based bonuses.

Political cost effects

•Decreased regulations;•Avoidance of higher taxes.


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Creative accounting

• Where those responsible for preparing accounts select accounting methods not objectively but according to the results desired by the preparers.

• Accounts preparers can be creative, yet at the same time follow financial reporting standards.

• Although they might not be objective, it might be difficult for parties such as auditors, with an oversight function, to claim that the financial report preparers are doing anything wrong.


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Creative accounting (contd..)

• According to Griffiths (1987):“Every company in the country (the UK) is

fiddling its profits. Every set of public accounts is based on books which have been gently cooked or completely roasted. The figures which are fed twice a year to the investing public have all been changed in order to protect the guilty….it is totally legitimate. It is creative accounting”.

Source: Creative accounting: how to make your profits what you want them to be.


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Creative accounting (contd..)

• While it must be acknowledged that creative accounting does occur, it is reasonable to argue that, with the increased number of financial standards being issued, the scope for being ‘creative’ should decrease.


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Some criticisms of PAT

• Normative theorists see PAT as Description not Prescription. The normative theorists see the role of accounting as prescription.

• But there are many researchers and research departments that still favor PAT.

• One widespread criticism of PAT is that it fails to provide prescription and, therefore, any means of improving accounting practice. It is argued that simply explaining and predicting accounting practice is not enough.


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Some criticisms of PAT (contd..)

• There is no guidance as to what people should do.

• This is normally justified by PAT theorists on the basis that they do not want to impose their own views on others.

• They would prefer to provide information about the expected implications of particular actions and let people decide for themselves what they should do.


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Some criticisms of PAT (contd.)

• The fundamental assumption of PAT is that ALL action is driven by a desire to maximize wealth.

• To many researchers such an assumption represents a perspective of humankind that is far too negative.

• Gray, Owen and Adams (1996) state that PAT promotes a morally bankrupt view of the world.


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• Another criticism of PAT is that since its general inception in the 1970s the issue being addressed have not shown any great development.


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• In Watts and Zimmerman (1987) there were three key hypotheses:

1. The debt hypothesis: Organizations that are close to breaching accounting based debt covenants will select accounting methods that lead to an increase in profits and assets.

2. The bonus plan hypothesis: Managers on accounting based bonus schemes will select accounting methods that lead to an increase in profits.

3. The political cost hypothesis: Firms subject to political scrutiny will adopt accounting methods that reduce reported income.


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• A review of the recent PAT literature indicates that these hypotheses continue to be tested in different environments and in relation to different accounting policy issues- even 25 years after Watts and Zimmerman formulated them.


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• Sterling(1990):“what are the potential

accomplishments [of PAT]? I forecast more of the same: twenty years from now we will have been inundated with research reports that managers and others tend to manipulate accounting numerals when it is to their advantage to do so.”


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• Christenson (1983):We are told, for example, that ‘we can only expect

a positive theory to hold on average’. We are also advised ‘to remember that as in all empirical theories we are concerned with general trends’, where ‘general’ is used in the weak sense of ‘true or applicable in most instances but not all’ rather than a strong sense of ‘relating to, concerned with, or applicable to every member of a class’…..a law that admits exceptions has no significance, and the knowledge of it s not of the slightest use. By arguing that their theories admit exception, Watts and Zimmerman condemn them as insignificant and useless.


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Concluding remarks

• While the criticisms do, arguably, have some merit, PAT continues to be used.

• A number of accounting research journals continue to publish PAT research.

• A number of the leading accounting research schools throughout the world continue to teach it.

• What must be remembered is that all theories of accounting will have limitations.

Accounting theory 9

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