DeeganFAT4e_PPT_ch07

7/25/2019 DeeganFAT4e_PPT_ch07

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7-2Copyright 2014 McGraw-Hill Education (Australia !ty "td!!#s to acco$pany %&&gan' Financial Accounting Theory 4&

"&arning o&cti/&s71 Understand how a positive theory differs from a normative

theory.72 Be aware of the origins of Positive Accounting Theory PAT!.

73 Understand that PAT uses insights from agency theory andwhy agency theory is of relevance to financial accounting

practices.74 Be aware of the central assumptions of PAT.

7 Be aware of the meaning and nature of agency costs.

75 Understand why an organisation can usefully be referred to

as a "ne#us of contracts$.

77 Understand the perceived role of accounting in minimising thetransaction costs of an organisation.

continued


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"&arning o&cti/&s (cont76 Be aware that accounting policy choices made by

management will be influenced by both efficiency

considerations as well as opportunistic motivations.

7 Be able to identify the reasons for the e#istence of "creativeaccounting$.

710 Be able to e#plain the meaning of "political costs$ and how

accounting can be used to reduce the costs associated withvarious political processes.

711 Understand the role of accounting%based managementcompensation schemes and debt covenants in reducingpotential conflicts agency costs! within an organisation.

712 Understand how particular accounting%based agreementswith parties such as debtholders and managers can provideincentives for managers to manipulate accounting numbers.

continued


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"&arning o&cti/&s (cont

713 Be aware of what constitutes "conservative$ accountingprocedures and why conservative accounting proceduresprovide efficient mechanisms for minimising the contractingcosts within an organisation.

714 Understand the relevance of PAT to current debates abouthow assets and liabilities should be measured.

71 Be able to identify some of the criticisms of PAT.


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7-Copyright 2014 McGraw-Hill Education (Australia !ty "td!!#s to acco$pany %&&gan' Financial Accounting Theory 4&

!ositi/& th&ori&s co$par&d to

nor$ati/& th&ori&s& A positive theory see's to e#plain and predict

particular phenomena

( Positive Accounting Theory PAT!) which we e#plore in thislecture) is one e#ample of a positive theory of accounting.

*ther e#amples are covered in the ne#t lecture when weconsider theories such as +egitimacy Theory andinstitutional theories which are positive theories that can beapplied to e#plain the practice of accounting!

& By contrast) normative theories which were

considered in Chapters , and -! prescribe how aparticular practice shouldbe underta'en

( the prescription might depart from e#isting practice


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!ositi/& Accounting #h&ory

d&8in&d

& PAT is concerned with explaining accountingpractice. 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. atts and /immerman 012-) p. 3!

& Again) positive theories do not prescribe what should

occur( they focus on e#plaining or predicting whatdoes occur

continued


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!ositi/& Accounting #h&ory d&8in&d

(cont

& PAT focuses on relationships between variousindividuals and e#plains how accounting is used toassist in the functioning of these relationships

& 4#amples of relationships

( between owners and managers

( between managers and the firm$s debt providers


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Assu$ptions und&rlying !A#

& All individuals$ action is driven by self%interest andindividuals will act in an opportunistic manner to thee#tent that the actions will increase their wealth

( does not incorporate notions of loyalty or morality


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7-Copyright 2014 McGraw-Hill Education (Australia !ty "td!!#s to acco$pany %&&gan' Financial Accounting Theory 4&

+rigins o8 !A#

& Started coming to prominence in mid%01-5s( paradigm shift from normative theories

& PAT became the dominant research paradigm in0135s and 0125s

( shift resulted from US reports on business education) andimproved computing facilities enabling large%scale statisticalanalysis ( something common in positive research


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+rigins o8 !A#9capital

$ar:&ts r&s&arch& Development of 4fficient 6ar'ets 7ypothesis 467!

by 8ama and others provided an environment suitablefor PAT research

( capital mar'ets react in an efficient and unbiased manner to

publicly available information

& Ball and Brown 01-2! paper was crucial to theacceptance of the positive research paradigm

( investigated stoc' mar'et reaction to accounting earningsannouncements

( sought to e#plain mar'et reactionscontinued


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+rigins o8 !A#9capital $ar:&ts

r&s&arch (cont& Price of a security based on beliefs about present value of future

cash flows

& Ball and Brown found that earnings announcements impactedshare prices

( evidence that historical cost information is useful to the mar'et

& But the literature was unable to e#plain why particular accountingmethods were selected ( if the mar'et was efficient as commonly

assumed by researchers) and could understand how differentaccounting methods affect accounting numbers) then why does itmatter what accounting method was selected9 PAT addressesthis issue


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ir$s and contracts

& 8irms can be characterised as a ne#us of contracts

( between consumers of products and the suppliers of factors ofproduction

& 8irms e#ist because they reduce contracting costs)

( firms provide an efficient means of organising economicactivity

( :consider the alternative) an individual organising theproduction of a good; ac


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+rigins o8 !A#9ag&ncy th&ory

& Agency theory was crucial to the development ofPAT

& Agency theory e#plained why the selection ofparticular accounting methods might matter

& 8ocused on the relationships between principals andagents

( e.g. between shareholders principals! and managersagents!

& >nformation asymmetries create much uncertainty

( transaction costs and information costs e#ist


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Ag&ncy r&lationship

& The "agency relationship$ is a central focus of agencytheory

& Defined by ?ensen and 6ec'ling 013-!

( a contract under which one or more (principals) engageanother person (the agent) to perform some service on theirbehalf which involves delegating some decision-maingauthority to the agent

& Agency theory 'ey assumptions from the economicsliterature) such as;

( assumptions of self%interest and wealth ma#imisation


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!ric& prot&ction

& >n the absence of contractual mechanisms to restrictagents$ potentially opportunistic behaviour) theprincipal will pay the agent a lower salary

( compensates principals for adverse actions

& Agents will therefore have incentives to entercontracts which appear to limit actions detrimental toagents


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#h& ag&ncy prol&$

& At the core of the analysis is the "agency problem$

& The agency problem relates to issues associatedwith motivating one party the agent! to wor' in thebest interests of another party the principal!

& Agency problems arise because of inefficienciesand information asymmetries

& The agency problem leads to "agency costs$


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Ag&ncy costs& 6onitoring costs

( costs of monitoring agents$ behaviour

( e.g. auditing financial statements

& Bonding costs

( costs involved in agents bonding their behaviour toe#pectations of principals

( e.g. preparing financial statements

& @esidual loss

( too costly to remove all opportunistic behaviour


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ol& o8 accounting in

contracts

& Accounting information is used to address theagency problem and to reduce agency costs

& Accounting is used as a monitoring and bondingmechanism to control the efforts of self%interestedagents managers!


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;&y hypoth&s&s

& Three 'ey hypotheses fre


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%&t hypoth&sis

& The higher the firm$s debte


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!olitical cost hypoth&sis

& +arge firms rather than small firms are more li'ely touse accounting choices that reduce reported profits

( sie is a pro#y variable for political attention

( reduction of reported income is hypothesised to reduce the

possibility that people will argue that the organisation ise#ploiting other parties


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#wo p&rsp&cti/&s adopt&d y

!A# r&s&arch

& 4fficiency perspective

& *pportunistic perspective


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E88ici&ncy p&rsp&cti/&

& @esearchers e#plain how contracting mechanismsminimise agency costs of the firm

& nown as ex anteperspective

( mechanisms put in place up front to minimise future agency

and contracting costs

& 6anagers select accounting methods which mostefficiently reflect underlying firm performance

& PAT theorists argue that regulation forcing firms to

use a particular accounting method imposesunwarranted costs and introduces inefficiencies


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+pportunistic p&rsp&cti/&

& See's to e#plain managers$ actions once contractsare already in place

& That is) particular accounting methods might initiallybe selected for efficiency reasons) but once theyhave been negotiatedagreed) then managers will

aim to utilise accounting choices in a way that bestserves their own interest

& ot possible to write complete contracts) somanagers are assumed to opportunistically act to

ma#imise own wealth& nown as ex post perspective

( considers opportunistic actions after the fact


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+wn&r=$anag&r contracting

& Assuming self%interest) owners e#pect managersagent! to underta'e activities not always in the interestof owners principal!

& 6anagers have access to information not alwaysavailable to principals

( information asymmetry

( further increases managers$ ability to underta'e activitiesbeneficial to themselves

& Costs of divergent behaviour are agency costscontinued


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+wn&r=$anag&r contracting (cont

& >n the absence of controls to reduce opportunisticbehaviour) agents managers! e#pected to underta'eactivities disadvantageous to the value of the firm

& Principals price this into the amounts they areprepared to pay the manager

& 6anagers may contract themselves not to consumeper's so will receive higher salary

( 'nown as bonding


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M&thods o8 r&warding

$anag&rs& 8i#ed basisEsalary independent of performance

( manager may not ta'e great ris's as does not share inpotential gains

& Salary plus remuneration is) in part) tied to firmperformance

( 'nown as bonus schemes


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Accounting-as&d onus

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 onthe old method in place so changes will not affectbonuses

& Contracts relying on accounting numbers may relyon "floating$ FAAP


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)nc&nti/&s to $anipulat&

accounting nu$&rs&

The decision to reward managers on the basis ofaccounting profits might initially be introduced forefficiency reasons it motivates them to wor' in a waythat also benefits the principals!) but it maysubse


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)nc&nti/&s to $anipulat&

accounting nu$&rs9&/id&nc&&

7ealy 012,! found;( managers adopt accounting methods to ma#imise bonus if

contract rewarded managers after a pre%specified level ofearnings reached

( if income not e#pected to reach pre%specified minimum)

managers shift earnings to future period "ta'e a bath$!

& +ewellen) +oderer and 6artin 0123! found;

( US managers approaching retirement are less li'ely tounderta'e @ID e#penditure if rewards based on accounting%based performance measures

( short%term focus


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,s& o8 cons&r/ati/& accounting $&thods

in $anag&$&nt onus sch&$&s

& Conservative accounting methods) which would includehistorical cost) tends to delay the recognition of income)accelerate the recognition of e#penses) and lead to lowerasset and higher liability recognition

& Asset and income recognition based on assessments of

fair value would not be considered a "conservative$accounting approach

& Potential conflicts of interest between agents andprincipals are better managed when conservative

accounting methods are used as they restrict the abilityof managers to opportunistically use income and netasset increasing accounting methods


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Mar:&t-as&d onus sch&$&s& Apart from accounting%based bonus schemes)

managers are also often provided with capital mar'et%based bonuses

& 6ay be more appropriate to remunerate managers interms of mar'et value of firm$s securities shares!where accounting earnings fluctuate greatly

( e.g. mining) or high technology @ID firms

( or where managers are approaching retirement

& 6ethods include;

( cash bonus based on share price increases( shares

( options to buy sharescontinued


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Mar:&t-as&d onus sch&$&s (cont

&Providing managers with shares) or share optionscreates incentives for managers to increase thevalue of the firm ( aligns their interests with those ofthe owners principals!

& But) problems include;

( share price also affected by factors beyond the control ofmanagers e.g. general mar'et movements!

( only senior managers li'ely to have a significant impact onshare value

continued


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Mar:&t-as&d onus sch&$&s (cont& But remember) regardless of how managers are rewarded there is

always a maintained assumption within PAT that managers and

everybody else! will be opportunistic& Consider results of Bartov and 6ohanram J55K!;

( In presence of deteriorating profitability managers are liely to adoptincome increasing accounting methods to increase share prices and

therefore the value of their share options. !hey would then exercise their

share options thereby ac"uiring the shares# and fairly "uicly sell the

shares before reported profits ultimately decline and the value of the

shares fall

& Aboody and asni' J555!;

( if managers now that share options were to be granted to them they willdisclose bad news so as to reduce share prices and therefore the liely

future exercise price of the share options. !his would mean that when they

ultimately exercise the granted options# thereby buying the underlying

shares# they will pay less and therefore mae greater financial gain


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Choic& o8 accounting /&rsus

$ar:&t-as&d onus sch&$&s& 6anagers$ bonuses are more li'ely to be based on

accounting earnings where;

( share returns relatively more sensitive to general mar'etmovements

( earnings have a high association with firm%specificmovement in the firm$s share values

( earnings have a less positive association with mar'et%widemovements in e


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%&t contracting9ag&ncy

costs o8 d&t&

6oving our attention to the relationship withdebtholders) in the absence of safeguards to protectdebtholders creditors!) managers are predicted toadopt strategies to disadvantage the debtholders

& Agency costs of debt created by managers include( e#cessive dividend payments) which leave fewer assets to

service debt

( the organisation may ta'e on additional debt) with newdebtholders competing with original debtholders for repaymentclaim dilution!

( investment in high%ris' proHects may not be beneficial to debtholders as they have a fi#ed claim asset substitution!

( underinvestment


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,s& o8 d&t contracts

& >n the absence of safeguards to protect the interests

of debtholders from strategies such as those on theprevious slide) it is assumed the debtholders willre


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E/id&nc& 8ro$ Australian d&t

contracts& >n relation to Australian debt contracts) Cotter 0112!

found;

( leverage covenants fre


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Australian d&t contracts (cont

( debt to assets) interest coverage and current ratio clausesfre


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Australian d&t contracts (cont

& 6ather and Peirson J55-! provide evidence of a

change in the use of covenants relative to earlierperiods. Their findings include;

( a reduction in the use of debtasset restrictionsM

( greater variety of debt convents being usedM

( more common covenants include minimum interestcoverageM minimum dividend coverageM minimum currentratioM minimum re


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#h& rol& o8 cons&r/ati/& accounting $&thods

in r&ducing th& ag&ncy costs o8 d&t

& As with management bonus schemes) it is believed that the useof conservative accounting methods are relatively moreeffective in reducing agency costs of debt

& /hang J552! suggests that from an efficiency perspective)managers might agree to adopt conservative accounting

methods because it allows them to attract debt at a lower price

& The use of conservative accounting procedures means thatdebt covenants restricting the amount of debt relative to assetsor debt to e


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7-44Copyright 2014 McGraw-Hill Education (Australia !ty "td

!!#s to acco$pany %&&gan' Financial Accounting Theory 4&

#h& rol& o8 cons&r/ati/& accounting $&thods in

r&ducing th& ag&ncy costs o8 d&t (cont

& As /hang J552! argues) the more binding covenants willprovide an earlier warning of default ris') and will therebyreduce the ris' e#posure of the lending party for e#ample)a ban'!

& The reason for this is that) because management will have

less ability to circumvent restrictive covenants for e#ample)by underta'ing asset revaluations!) such covenants willcreate a technical default of a loan agreement earlier than ifmanagement has the scope to loosen the restrictions

& The earlier the lender can ta'e action to safeguard itsfunds) the lower the ris' to the lender


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%&t contracts9$anag&r>s

inc&nti/& to $anipulat&& $x post) the incentive to manipulate accounting numbers

increases as the accounting%based debt covenants approachviolation

& 6anagers found to manipulate accounting accruals in the

years before and the year after violation of a debt agreement

& Too costly to stipulate all acceptable accounting methods incontract so managers always have some discretionary ability

& But as we have learned) contracts that re


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ol& o8 &?t&rnal auditors

& Auditors arbitrate on the reasonableness of theaccounting method chosen

& Demand for financial statement auditing when;

( management is rewarded on the basis of numbersgenerated by the accounting system

( the firm has borrowed funds) and accounting%basedcovenants are in place to protect the investment of

debtholders


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!olitical costs& e have already indicated that financial accounting numbers

are important with respect to debt contracting andmanagement compensation contracting. 8inancial accountingalso plays a 'ey role in the political process

& Political costs are costs resulting from political attention fromgovernment) lobby groups etc.

& Commonly directed at larger firms

( indication of mar'et power

& 6ay result in increased ta#es) increased wage claims)

product boycotts etc.

& 8irms li'ely to adopt accounting methods to reduce profits tolower political scrutiny


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!olitical actions o8 indi/iduals

& +imited e#pected "pay%off$ results from the actions ofindividuals

& @esults in formation of interest groups

& >nformation costs shared) ability to investigategovernment and business action increases

& Fiven self%interest) representatives of interest groupspredicted to ma#imise own welfare as constituentshave limited motivation or means to be fully informed


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Actions o8 politicians

& Politicians 'now that highly profitable companiescould be unpopular with members of theirconstituency

& Politicians who are assumed to be driven by self%interest li'e everybody else! could win votes byta'ing actions against the companies

( argue that it is in public interest even though in own interest

& 6ay rely on reported profits to Hustify actions

( provides incentives for firms to reduce reported profits

E?a$pl& o8 how politicians us& accounting


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E?a$pl& o8 how politicians us& accounting

nu$&rs as a $&ans o8 usti8ying actions

against an organisation

& As reported in the %obart &ercuryon 1 6arch J50N) the AustralianFreens political party used the sie of ban' assets and profits as thebasis for levying additional ta#es on ban's. The article stated;

The Freens want a levy of 5.J per cent on all ban' assets above O055 billion inreturn for 8ederal Fovernment guarantees) which the independentParliamentary Budget *ffice has costed as raising O00 billion over the ne#t fouryears.

At a time when thereQs pressures on the budget) and the government isloo'ing around for ways of raising revenue) especially in light of the failedmining ta#) who can afford to pay it the most9R Australian Freens$ 6r Bandtsaid yesterday.

R>f we donQt stand up to the big ban's and the big miners) then the +abor Partyis going to come after the rest of us) li'e they have with single parents) and li'e

they are threatening with the forthcoming budget.R

& As we can see) "profits$ are used to Hustify the proposed action. +owerreported profits would provide less "ammunition$ for the politicians

&l&/anc& o8 !A# as&d r&s&arch to curr&nt


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&l&/anc& o8 !A#-as&d r&s&arch to curr&nt

&88orts o8 )A@< to pro$ot& us& o8 8air /alu&s& As already indicated in this lecture) conservative

accounting methods lead to;( relatively lower revenue recognition

( faster e#pense recognition

( higher liability recognition

( lower asset recognition

& 7istorical cost accounting is a conservative approach toaccounting when compared to fair value accounting

& Conservative accounting methods) such as historical

costs) reduce the ability of managers to manipulateaccounting numbers compared to fair value accounting

continued

l 8 !A# d h t t 88 t


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&l&/anc& o8 !A#-as&d r&s&arch to curr&nt &88orts

o8 )A@< to pro$ot& us& o8 8air /alu&s (cont

& Do the ongoing efforts of the >ASB to embrace fair values

ma'e sense from an efficient contracting perspective9

& Because conservative accounting methods reduce thepossibility that management will underta'e opportunisticearnings management) organisations that use conservative

accounting methods might be able to attract debt ande


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&l&/anc& o8 !A#-as&d r&s&arch to curr&nt &88orts

o8 )A@< to pro$ot& th& us& o8 8air /alu&s (cont

& hilst information about fair values will be useful tovarious financial sta'eholders in terms of assisting them toma'e informed investmentresource allocation decisions)more conservative accounting methods also providebenefits in terms of controlling potentially divergent

behaviour of individuals involved in various contractualarrangements.

& There is a clear%trade%off between the advantages ofhaving relevant information about current values and the

contracting benefits that more conservative accountingbenefits provide


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Criticis$s o8 !A#

& Does not provide prescription

& PAT is not value%free as it asserts assumption that allaction is driven by self%interest

& Argued to be too negative and simplistic a

perspective of human'ind& >ssues have not shown great development

& >n underta'ing large%scale empirical research)researchers ignore organisational%specificrelationships

%iagra$$atic su$$ary o8 !A#


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%iagra$$atic su$$ary o8 !A#

DeeganFAT4e_PPT_ch07

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